In our country, the reserve bank of India works as central bank and controls all the nationalized banks. It formulates and administers monetary policies for the purpose of controlling the supply of money or liquidity in the economy to stimulate economic growth. Repo rate and Reverse repo rate are tools of RBI’s monetary policy.
What is Repo Rate?
The term ‘Repo’ stands for ‘repurchase agreement ‘. Repo is a short term, collateral-based borrowing and interest rate for such borrowings is termed as repo rate. In other words, the repo rate refers to the rate at which commercial banks borrow money by selling their government securities to RBI to maintain liquidity, in case of a shortage of funds.
How does Repo Rate affect the economy?
Repo rate is an important part of Indian monetary policy that regulates the money supply, inflation levels, and liquidity in our country. Moreover, the repo rate has a direct impact on the cost of borrowings for banks. Higher the repo rate, the higher will be the cost of borrowings for banks and vice versa.
- To control inflation: At high levels of inflation, RBI strongly attempts to bring down the liquidity in the economy. This can be done by increasing the Repo rate. This makes the borrowing costs for businesses and thus slows down the investment and money supply in the market.
- To control liquidity in the market: In turn, when RBI needs to infuse funds into the system, it decreases the repo rate. Hence, businesses and industries find it cheaper to borrow money for various investment purposes. It increases the overall supply of money and boosts the growth rate.
What is Reverse Repo Rate?
As the name suggests it is opposite to repo rate. Reverse repo rate is the rate at which RBI borrows funds from commercial banks in the country. Generally, it is the rate at which commercial banks in India park their excess money with RBI for the short term.
How does Reverse Repo Rate affect the economy?
This is a mechanism to absorb the liquidity in the market. RBI borrows money from banks when there is surplus money in the banks. The banks make a profit out of it by receiving interest in their holdings with the central bank.
At high levels of inflation in the economy, the RBI increases the reverse repo rate. It boosts the banks to park more funds with the RBI to earn higher returns on excess funds. Banks are left with lesser to give loans and borrowings to consumers.
Repo Rate and Reverse Repo Rate are differentiated as below:
- A high repo rate helps reduce excess liquidity from the market, on the other hand, a high reverse repo rate helps increase liquidity in the market.
- Repo rate is used to control inflation whereas the reverse repo rate is used to control the money supply.
- The repo rate is always higher than the reverse repo rate.
This can also be understood by this :