What is Repo Rate?
The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa.
When repo rate increases
- Banks lend from RBI at a higher rates of interest
- They lend it to borrowers at a high rate of interest
- As lending interest rate increases, borrowing of money decreases
- Increase in the deposit interest rate to attract depositors
When repo rate decreases
- Increase in money supply in economy
- Increase in demand of goods
- Increase in GDP growth
Effects of Repo rate on Inflation
When the repo rate is raised, banks are compelled to pay higher interest to the RBI which in turn prompts them to raise the interest rates on loans they offer to customers. The customers then are dissuaded in taking credit from banks, leading to a shortage of money in the economy and less liquidity. So, while on the one hand, inflation is under controlled as there is less money to spend, growth suffers as companies avoid taking loans at high rates, leading to a shortfall in production and expansion. For instance, if the availability of funds is scarce, and banks are not able to borrow at repo rate, they may have to increase the deposits rates upwards to attract depositors. Hence, any rate hike in repo rate increases the probability of higher deposit rates, which is good news for depositors.
Impact on Sectors
Sectors such as automobiles, consumer durables and realty are the most vulnerable in the scenario where policy rate hikes push the interest rates. Rising rates would not only reduce the demand for these companies’ products, they will also affect their earnings in terms of rising interest costs. Rising rates would also impact companies with higher leverage. Besides, there is a possibility that more money gets allocated to debt than equities given the risk-return tradeoffs.
What is Reverse Repo Rate?
Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands with a good interest. An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.
Reverse Repo rate effect on inflation
If RBI increases this Reverse Repo rate, it means RBI wants to contraction of credit. When RBI gets loan from banks at high rate of interest, more and more banks will supply to central bank because it is safe and earning is more. Effect of this will on financial market. Supply of money in financial market will decrease. Due to decrease in the supply of credit in the market, inflation rate will decrease.
Repo and Reverse Repo Trends: