We all know that the Reserve Bank of India (RBI) is the Central bank of India. Repo rate is the rate at which the commercial banks can borrow money from the central bank. And reverse repo rate is the rate at which the commercial banks deposit money at the central bank (RBI). Repo is a short form of repurchase agreement. This is an exchange of money for Bond between commercial banks and the central bank.
Repo rates and reverse repo rates are also used as a tool by the central banks to infuse or decrease money supply in the economy. Now lets see how it is used as one of the tool to monitor inflation
Assume that the economic growth rate is deteriorating and there is less money with people to spend. As people will not be motivated to buy products or services from the business. In such a case, businesses won’t be motivated to borrow loans and make any investment to develop business.
How does reducing repo rate motivates people to borrow?
Reducing Repo rate encourages commercial banks to borrow more money from the central bank (RBI) for a lower interest rate and lend more to the public. This induces people to borrow more from the bank and spend more. As people borrow money for house loans, car loans etc., demand in the market increases and there is an increase in inflation. Thus the Inflation helps the economy to grow.
When does the central bank increase repo rate?
Inflation is also bad when it is above the threshold. Nobody wants to go to a nearby store and buy things for a higher price. Increasing inflation above a certain limit also affects the economy. Cost of raw materials will also increases and the business profit will be reduced. Businesses will be less motivated to invest money in the business for lower profit. In that case, RBI increases Repo rate to bring the inflation in control. Now the banks will not take more risk by borrowing at a higher rate from the central bank. Therefore the banks will not lend much and the people will in turn spend less. The demand goes down in the economy due to which the inflation comes down. Therefore the cost of manufacturing also comes down. Yes! It looks like a cycle.
Then how does the reverse repo rate work?
Conversely, reverse repo rate is the rate at which commercial banks deposit money with the central bank. This is generally used by the central bank to pull the money from the system/economy. If the central banks increase reverse repo rate, then the banks might deposit it’s money with the central bank with reasonable returns rather than lending it to the economy at high risk. This follows the same cycle of reducing the inflation in the economy by reducing the money available with people.
What happens if the reverse repo rate is decreased? The commercial banks are not incentivised enough to deposit money with the central bank. Therefore banks will rather lend loans to the public and get higher returns than depositing it with the central bank for a lower rate. This leads to lending more to the people and increasing money supply in the economy
This is how repo and reverse repo rate can be used to impact inflation.
Happy learning Until next time!