What is a Repo Rate?
Repo rate refers to the rate at which the Reserve Bank of India grants loans and advances to the commercial banks of India. The money is lent by the RBI to the commercial banks to recover from any shortage of funds.
Repo rate is an important banking term commonly used in RBI circulars and in newspapers. You may have come across repo rate and its reduction in the news. But what exactly is the repo rate? Is it utilized while lending or borrowing by the Reserve Bank of India? How the RBI undertakes efforts to reduce inflationary pressured by using the instrument of repo rate? Let us discuss about the importance of understanding repo rate for a layman.
In general terms, repo rate is adopted by the central bank of the country. In India, the central bank is the Reserve Bank of India. It is used for providing loans and advanced to the commercial banks within India.
Situation in which repo rate is utilized
Banks may suffer from shortage of funds. Bank customers may not be interested in opening long-term deposits in the bank due to reduced rates of interest. In order to overcome this shortage of funds, these commercial banks of the country will approach the Reserve Bank of India for financial resources. At such crucial point of time, repo rate is utilized by RBI to provide funds to the commercial banks.
Repo rate and inflation
Repo rate is a monetary instrument for controlling the effects of inflation. For this, we must understand the relationship between inflation and repo rate. As the inflation spreads in the country, the RBI tends to enhance the repo rate so that the banks will not continue borrowing from it. This will result in reduction in the money supply in the entire economy. When the repo rate increases, the cost of borrowing from banks also increases. The public will be discouraged to borrow from banks. They will start depositing in the long-term bank accounts instead. Commercial banks start acquiring money from the customers. They can efficiently reduce the amount of borrowings to the customers. They also do not have to take efforts to make borrowings from the Reserve Bank of India. Due to higher interest rates, the credit availability also decreases. In this way, the inflation is controlled. The Reserve Bank of India is actually controlling the demand and supply forces in the economy.
In the case the inflationary pressures fall, the RBI takes an opposite step. It reduces the repo rate so that the commercial banks start borrowing from it. It results in increase in the money supply. Thus, we can say that repo rate is used in the monetary policy for injecting liquidity in the economy.
Thus, repo rate and reverse repo rate are used as important components of the liquidity adjustment scheme. It is used for tightening the monetary policy of the country.