In this article, we will provide a brief overview of RBI reverse repo rate, its impact on the economy, the difference between repo rate and reverse repo rate, and some important financial information.
An overview of RBI's monetary policies
The Monetary Policy Committee of RBI decides various monetary policies to maintain the money flow in the economy. It is the apex institute of India responsible for maintaining the price stability and growth in the economy of the country. To regulate inflation, deflation, and other critical economic situations, RBI introduced several monetary policies. The repo rate is the interest paid by the banks to the RBI while borrowing money, and the reverse repo rate is the interest rate paid by RBI to commercial banks for borrowing money from them. The current repo rate and reverse repo rate is cut down to 4% and 3.75% respectively. The CRR and SLR rate is 3% and 18% respectively. The other instruments of monetary policy are open market operations, bank rate policy, credit ceiling, credit authorization scheme, and moral suasion.
The objectives of monetary policies are -
- Controls imports and exports oriented units.
- Maintains a healthy cash flow in the economy and promoting savings & investments.
- Regulate the boom and depression of the business cycle.
- Offering loans at low-interest rates and helps in business expansion. Thus regulating Employment.
- Help in the development of infrastructures.
- Manage the entire banking sector.
What is Reverse Repo Rate?
Reverse Repo Rate is the rate of interest paid by RBI to the commercial banks while borrowing money. This tool maintains the flow of money in the market and especially fights against inflation. The extra fund of a financial institution is lent, to the RBI for a short term duration, and in return, RBI offers a rate of interest on the amount to the institution. No securities, like treasury bills, are issued by RBI against the funds. With the cut in reverse repo rate, the demand for basic goods, and advances from commercial banks, is expected to observe a substantial growth throughout the country. The reverse repo rate maintains the market price stability and boosts the economic growth of the country.
The significance of the reverse repo rate is the liquidity regulations and money supply in the market. When the commercial banks suffer a money shortage, they can borrow from RBI at repo rate. Whereas, an excess fund in the banks can be lent, to the RBI, at reverse repo rate. In case of borrowing money, the banks need to pay interest to RBI depending on the RLLR whereas for lending money they can earn interest from the RBI. Thus, regulating the liquid flow in the market. When there is a greater cash flow in the market, the central bank increases the reverse repo rate, attracting the banks to lend money. But, during the money shortage in the market, the reverse repo rate is decreased, the money flow in the market becomes smooth.
Importance of Repo rate and Reverse Repo Rate
- They are responsible for maintaining the money flow control mechanism. They deal with fund deficiency and liquidity in the economy.
- Bank lending rates are dependent on these monetary tools. The money flow control mechanism is largely maintained by them.
- These are the most effective and efficient monetary tools of RBI used to maintain price stability and economic growth.
- Controls inflation. Maintains a balance between economic growth and inflation in the market.
Impact of Reverse Repo Rate on the economy
When the reverse repo rate increases, the commercial banks get tempted to earn more interests from the RBI. They lend the extra funds to the central bank and enjoy the interest paid by it. In return, the RBI provides government securities to the banks. This reduces the liquidity of the banks and it is the safest mode of investment instead of lending to individuals or businesses.
The reverse repo rate is increased by RBI to fight with inflation. With an increase in the rate, the banks deposit the extra funds for earning more interest, the money supply decreases, thus control inflation. When the money supply in the economy decreases, the strength of rupees gets boosted. To stroke inflation, the rates are decreased, this allows the free flow of money in the market. This lowers the rate of interest on loans approved by the banks. The excess money is no more deposited in RBI rather are invested in alternative lucrative sectors like money markets or to individual borrowers.
What is Repo Rate?
Repo rate is launched by the Monetary Policy Committee of the RBI. When a Commercial Bank faces a monetary crisis, they ask the Reserve Bank of India to lend money at a particular rate of interest is known as the repo rate. This controls the money flow in the economy and fights inflation. When there is a huge sum of money in the market the RBI increases the repo rate. As the repo rate increases commercial Banks stop borrowing more money and this reduces the money flow in the entire system. During deflation, the central bank reduces the repo rate, so that Banks can borrow a large amount of money, and thus increases the money flow in the economy.
Under the new RBI guidelines, the banks have been instructed to allow existing loan borrowers to switch from MCLR to repo rate linked home loans. Buying a home loan with this external Benchmark is beneficial for borrowers. When the repo rate decreases, the Home Loans are offered at a low rate of interest. But a certain change in the repo rate may directly make an impact on the home loan EMIs.
The repo rate on a home loan is dependent on two parameters - the reset frequency of the interest and the spread of the external benchmark. Further, the spread includes a base spread and an additional spread. The repo rate is made fixed at the beginning of the loan approval and remains the same throughout the repayment period. Depending on the RBI's decision the repo rate can be changed at any time. This is the drawback of RLRR.
Difference between Repo Rate and Reverse Repo Rate
The difference between Repo Rate and Reverse Rep are as follows -
- With the repo rate, the commercial banks borrow money from RBI against government securities. Whereas, with reverse repo rate, the RBI pays a rate of interest to the banks, lending their surplus funds.
- The rate of interest for the repo rate is higher than the reverse repo rate.
- The repo rate controls inflation by increasing the rate, this decreases the flow of money in the market as the banks face difficulty in borrowing money. The reverse repo rate controls inflation, by increasing the rate. This attracts the banks to deposit their extra funding to earn a profit, thus decreasing the money flow in the economy.
- The purpose of the repo rate is to fill up the fund deficiency but the reverse repo rate ensures liquidity in the market.
- Reverse repo rate can be charged on the Reverse Repurchase Agreement while the other one is charged on Repurchase Agreement.
- The impact on banks with increased repo rate is increasing in the cost of banking products. The impact with increased reverse repo rate is increased in surplus fund lending activity.
Also read : Repo Rate Linked Home Loan Calculator
Q1. What is CRR?
Ans. CRR is referred to as the Cash Reserve Ratio. This is the percentage of total bank deposits kept in the RBI. This amount cannot be lent to an individual or corporate borrowers. When the CRR is reduced by RBI, the money in the bank increases allowing more money lending and investments. This increases the money flow in the economy
Q2. What is SLR?
Ans. SLR is referred to as the Statutory Liquidity Ratio. It is the bank deposits that are specified for various financial securities. Banks earn interests from this investment.
Q3. What is Overnight Repo?
Ans. When a repo transaction is made for a day is termed as an overnight repo. In this case, the commercial bank sells some financial securities to the RBI for borrowing money, and the next day repurchases the securities, by returning the borrowed money.
Q4. What is Term Repo?
Ans. When a repo transaction is made for more than a day and includes a period that maybe 7 days, 14 days, or a maximum of 28 days. When the banks need funds, the RBI announces a repo auction. Here the funds are provided for more than one day.