Repo Rate and Reverse Repo Rate - Components, Importance and Effects of Increase & Decrease

Reserve Bank of India formulates and oversees monetary policies explicitly to control the supply of money in the economy to animate different parts of economic growth. The essential target of such monetary policies are advancing economic development through price stability, regulation of the volume of bank credits, improving efficiency of the financial system, advancing investments and expanding diversification in financial markets.

In this context, repo rate and reverse repo rate are instruments of RBI's monetary policy that can help control the money supply in the economy.

Repo Rate

Repo rate alludes to the rate at which commercial banks acquire money by selling their securities to the Central bank of our country i.e Reserve Bank of India (RBI) to look after liquidity, in case of shortage of funds or because of some statutory measures. It is one of the primary devices of RBI to monitor inflation.

How Does Repo Rate Work?

At the point when you get money from the bank, the transaction draws in interest on the principal amount. This is alluded to as the cost of credit. Additionally, banks likewise get money from RBI during a cash smash on which they are needed to pay interest to the Central Bank. This interest rate is known as the repo rate.

In fact, repo means 'Repurchasing Option' or 'Repurchase Agreement'. It is an agreement wherein banks give eligible securities, for example, Treasury Bills to the RBI while profiting overnight loans. An agreement to repurchase them at a predetermined price will likewise be set up. This way, the bank gets the cash and the central bank the security.

What are the Components of a Repo Transaction?

The following are the boundaries based on which the RBI consents to execute the transaction with the banks:

Forestalling Economy "squeezes" – The Central bank increments or diminishes the Repo rate contingent upon the inflation. In this manner, it targets controlling the economy by keeping inflation in the cutoff.

Hedging and Leveraging – RBI intends to hedge and leverage by buying securities and bonds from the banks and give cash to them in return for the collateral deposited.

Short-Term Borrowing – RBI lends money for a short timeframe, most extreme being an overnight post which the banks buy back their securities deposited at a predetermined price.

Collaterals and Securities – RBI acknowledges collateral as gold, bonds and so forth

Cash Reserve (or) Liquidity – Banks acquire money from RBI to keep up liquidity or cash reserve as a precautionary measure.

Reverse Repo Rate

Reverse Repo Rate is a component to retain the liquidity on the lookout, in this way confining the borrowing power of investors.

Reverse Repo Rate is the point at which the RBI gets money from banks when there is abundance liquidity on the lookout. The banks advantage out of it by accepting interest for their holdings with the central bank.

During significant levels of inflation in the economy, the RBI builds the reverse repo. It urges the banks to stop more funds with the RBI to acquire better yields on abundance funds. Banks are left with lesser funds to stretch out loans and borrowings to consumers.

(Also Read: Statutory Liquidity Ratio (SLR))

Importance of Repo Rate and Reverse Repo Rate

Liquidity Regulation: Under the liquidity framework planned by RBI, numerous offices are offered to commercial banks to meet their prerequisite of quick liquidity or deficiency of funds.

The fundamental intention of the liquidity framework is to maintain a strategic distance from any liquidity crisis in the Indian banking system through implementation of repo agreements. In the comparable manner, RBI has a framework for overseeing surplus funds/cash in the banking system which guarantees there is no overabundance liquidity in the system. Furthermore, this framework is alluded to as reverse repo.

Essentially, repo transactions infuse liquidity into the Indian banking system. On the other hand, reverse repo retains liquidity from the Indian banking system.

Inflation Control: Reserve Bank of India holds a critical responsibility concerning finding some kind of harmony among inflation and economic growth by dealing with the repo rate as well as reverse repo rate intermittently.

By changing the repo/reverse repo rate, the RBI can control money flow for example liquidity in the economy – an excess of liquidity for the most part prompts inflation which can antagonistically influence the economy, while too little liquidity can prompt an economic slowdown.

Effect of Increase in Repo Rate and Reverse Repo Rate by RBI

Coming up next is the effect of expansion in repo rate and reverse repo rate by the RBI:

Expansion in Repo Rate: Increase in repo rate makes borrowing from the RBI more costly for commercial banks and this can prompt expansion in rates relevant to loans. As the interest rates on different loans increments, less loans are applied for dispensed, which confines the money supply in the economy and may antagonistically influence the country's economic growth.

Expansion in Reverse Repo Rate: If there is unreasonable liquidity in the banking system, RBI may choose to expand the reverse repo rate. When there is a climb in reverse repo rate, banks can procure higher interest on their abundance funds deposited with the Reserve Bank of India. This is a more secure investment option for banks so generally speaking flow of money into the markets will be diminished as a greater amount of the bank's surplus funds are deposited with RBI as opposed to being loaned out.

(Also Read: Cash Reserve Ratio (CRR))

Effect of Repo Rate and Reverse Repo Rate cuts by RBI

Coming up next is the effect of repo rate and reverse repo rate cuts by RBI:

Repo Rate Cut Impact: Banking is the primary area to get influenced by any change in monetary policies. A cut in repo rate can permit banks to get from the Reserve Bank of India at a less expensive rate and imbue higher liquidity in the banking system. This can lead banks to lessen their loaning rates for client prompting less expensive loans in the long term.

As bank loans get less expensive, consumers can acquire and spend more which supports consumption and can at last prompt economic growth. Be that as it may, this is relies upon the decision by the bank whether to pass on the RBI repo rate cut advantages to their clients through less expensive advance offers.

Reverse Repo Rate Cut Impact: Whenever RBI chooses to decrease the reverse repo rate, banks bring in less on their abundance cash deposited with the Reserve Bank of India. This leads the banks to invest more money in more lucrative avenues, for example, money markets which builds the general liquidity accessible in the economy.

While this can likewise prompt lower interest rate on loans for the bank's clients, the decision will rely upon numerous elements including the bank's internal liquidity situation and the accessibility of other possibly safer and equally lucrative investment openings.