Repo rate is nothing but the rate of interest at which the Reserve Bank of India (RBI) lends money to commercial banks. ”Repo” stands for Repurchase Agreement or Repurchasing Option.
Usually banks borrow money by selling their securities to the Central bank of our country i.e Reserve Bank of India (RBI) to maintain liquidity, in case of shortage of funds or due to some statutory measures. It is one of the main tools of RBI to keep inflation under control.
How Does Repo Rate Work?
When you borrow money from the bank, the transaction attracts interest on the principal amount. This is referred to as the cost of credit. Similarly, banks also borrow money from RBI during a cash crunch on which they are required to pay interest to the Central Bank. This interest rate is called the repo rate.
As mentioned earlier, it is an agreement in which banks provide eligible securities such as Treasury Bills to the RBI while availing overnight loans. An agreement to repurchase them at a predetermined price will also be in place. Thus, the bank gets the cash and the central bank the security.
How RBI controls the inflation?
When the market is hit by inflation, RBI increases the repo rate. An increased repo rate denotes that the banks who borrow money during this period from the central bank will have to pay higher interest. This discourages the banks to borrow money, which in turn, reduces the supply of money in the market and helps negate the inflation. Similarly, the repo rates are decreased in the case of a recession.
RBI calculates the repo rate on the basis of the economic condition. The rates are decided by the central bank on the basis of the inflation or recession in the market of the country.
Impact of Repo rate on the economy:
Repo rate is a powerful arm of the Indian monetary policy that can regulate the country’s money supply, inflation levels, and liquidity. Additionally, the levels of repo have a direct impact on the cost of borrowing for banks. Higher the rate, higher will be the cost of borrowing for banks and vice-versa.
Rise in inflation:
During high levels of inflation, RBI makes strong attempts to bring down the flow of money in the economy. One way to do this is by increasing the repo rate. This makes borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the market. As a result, it negatively impacts the growth of the economy, which helps in controlling inflation.
On the other hand, when the RBI needs to pump funds into the system, it lowers the repo rate. Consequently, businesses and industries find it cheaper to borrow money for different investment purposes. It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.
Repo Rate vs Reverse Repo Rate:
The difference can be listed as follows:
- Repo rate is charged against funds lent by the RBI to commercial banks and other financial institutions. The reverse repo rate, on the other hand, is the rate of interest that is offered by the central bank to the commercial banks who deposit funds in the RBI treasury.
- Repo rate is always higher than the reverse repo rate.
- Repo rate helps to control the inflation in the market. The reverse repo rate, on the other hand, helps to control the supply of money in the market
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