Monetary policies in India are formulated by the Reserve Bank of India (RBI) to stimulate economic growth. These policies are drafted for controlling the money supply and interest rate and cost of money in the economy. They bring in the price stability, regulates the bank credits, makes the financial system more efficient and promotes investments. The two key elements of monetary policies are the repo rate and reverse repo rate.

WHAT IS REPO RATE?

Repo stands for ‘Repurchase agreement’ and constitutes short-term borrowings for which interest is charged and which are backed by collateral. The interest rate which is charged is called the repo rate.

It is that rate of interest which is charged by the Reserve bank of India when it lends funds to the commercial banks in the country. The Repurchase agreement is signed by both the involved parties. Presently, the repo rate is 6.25%.

Effects of REPO RATE

Repo rate affects the banking sector, the common man and economy of the country in more ways than one.

On Banking System

Increase in repo rate - Rise or fall in repo rates has direct repercussions on lending rates and deposits. With an increase in repo rate, banks check on their liquidity position and cost of funds and start to shift the interest rate burden to its customers by increasing the lending rates. This hits the existing borrowers as their EMIs increases and new borrowers as they are charged a higher rate of credit. Loans with floating rates are the worst affected as higher rates of interest means reduced lending which ultimately affects the profitability of the banks. The banks can also increase the rate of deposit to get more inflow of cash after analyzing their liquidity position.
The decrease in repo rate - With a decrease in repo rate, banks are a happy lot as they can borrow from RBI at lesser rates. This can result in commercial banks reducing their lending rates after checking on the deposit inflows and liquidity condition. With bank loans getting cheaper, borrowings increases which ultimately increases the profitability of the banking sector.

On Common Man

Increase in repo rate - With an increase in repo rate, the borrowing of short term funds from RBI by commercial banks becomes costlier. Since the banks do not have access to low-cost funds, they shift the load to its customers by increasing the rate of lending. This results in loans getting costlier which automatically hampers the purchasing power of the consumers.

To encourage the flow of funds, the banks can offer a higher rate of interests for the fixed deposits. This attracts the customers as they tend to save more on deposits.
The decrease in repo rate - With a decrease in repo rate, commercial banks can avail short term funds from RBI at reduced rates. This results in loans getting cheaper. The common man can now avail loans and credits at a lesser rate of interests to meet their financial goals.

On Economy

Increase in Repo Rate - As the repo rate is increased, it tends to make the loans and borrowings expensive for the common man. With this, many borrowers stray away from availing credits which results in a reduction in the supply of money in the market. This stabilises the liquidity in the economic system. It also hampers consumption, expansion and production of goods and services which ultimately slows economic development and GDP growth of the nation. The inflation rate, however, comes under control. This is the reason why RBI revises the repo rate on a regular basis.
The decrease in repo rate - As the repo rate decreases, the commercial banks get access to cheaper short term funds. This results in banks offering loans and credits to their customers at cheaper rates as the base lending rates also reduces. With reduced lending rates, people will have more money to their disposal which will result in higher consumption, expansion and production. It impacts the GDP of the country positively. Employment opportunities also increase with expansion.

What is Reverse Repo Rate?

It is the opposite of repo rate and is defined as that rate at which commercial banks keep their excess money with the Reserve Bank of India for a short duration of time. Presently, the reverse repo rate is 6%.

Effects of Reverse Repo Rate

On Banking System

Increase in Reverse Repo Rate - RBI increases the reverse repo rate as and when there is excess money in the market. With the increase, banks get higher interest rates on the funds which they have lent to RBI. As the bank’s earnings increases, it will result in a profitable banking system.
The decrease in reverse repo rate - As the reverse repo rate decreases, so do the earnings of the banks who have lent money to RBI which means no positive impact on the profitability of banking business.

On Common Man

Increase in Reverse Repo Rate - Higher rate of inflation has a direct effect on the common man as they have to deal with the increased prices of commodities and basic utility things. With an increase in reverse repo rate, inflation will be reduced as there will be less money supply in the market as most banks start to supply excessive funds to the RBI.
The decrease in Reverse Repo Rate - It results in a decrease in banks earnings on investments which culminate to increase in inflation with more supply of money in the market. The common man faces the wrath of the increase in inflation.

On Economy
The main motive of increasing the reverse repo rate is to keep a tab on the inflation rate and absorb excess liquidity. This results in a reduction in the supply of money in the market which eventually reduces the rate of inflation.

Importance of Repo Rate and Reverse Repo Rate

RBI uses repo rate and reverses repo rate as a crucial money control mechanism to keep deficiency of funds and liquidity into check.

On the basis of these two rates, bank lending and investment rates are decided upon.

They are key elements to boost economic development and attain price stability which is used by the central bank of India.

A thorough balance between repo rate and reverse repo rate makes the economy and banking system powerful.

Significance of Repor Rate and Reverse Repo Rate

Liquidity Regulator: RBI upholds all the responsibility to avoid any kind of liquidity crises in the country’s banking system. It offers many facilities to the commercial banks of the country to take care of deficiency of funds. This liquidity framework is referred to as repo. It works to inject liquidity into the banking system.

RBI also takes care that there isn’t excess liquidity in the banking system and therefore has a framework defined for surplus funds/ cash which is referred to as reverse repo. It works by absorbing the liquidity from the banking system.

Price Stability: RBI revises the repo rate on a quarterly or half-yearly basis to maintain a steady balance between the rate of inflation and economic growth. Repo rate and reverse repo rate ensures that inflation remains within proportion.