- When we need money, we take loans from banks. And banks charge certain interest rate on these loans. This is called as cost of credit (the rate at which we borrow the money).
- Similarly, when banks need money they approach RBI. The rate at which banks borrow money from the RBI by selling their surplus government securities to RBI is known as “Repo Rate.” Repo rate is short form of Repurchase Rate. Generally, these loans are for short durations up to 2 weeks.
- It simply means Repo Rate is the rate at which RBI lends money to commercial banks against the pledge of government securities whenever the banks are in need of funds to meet their day-to-day obligations.
- Banks enter into an agreement with the RBI to repurchase the same pledged government securities at a future date at a pre-determined price. RBI manages this repo rate which is the cost of credit for the bank.
What is the effect of Repo rate changes on the economy?
Let us understand this with an example.
Example – If repo rate is 5% , and bank takes loan of Rs 1000 from RBI , they will pay interest of Rs 50 to RBI.
So, higher the repo rate, higher the cost of short-term money and vice versa.
Higher repo rate may slowdown the growth of the economy.
If the repo rate is low then banks can charge lower interest rates on the loans taken by us.
Reverse Repo Rate
Reverse repo rate is the rate of interest offered by RBI, when banks deposit their surplus funds with the RBI for short periods. When banks have surplus funds but have no lending (or) investment options, they deposit such funds with RBI. Banks earn interest on such funds.
What is the effect of Reverse Repo Rate on the economy?
- If the reverse repo rate is increased, it means the RBI will borrow money from the banks and offer them a lucrative rate of interest. As a result, banks would prefer to park their money with the rbi (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk).
- Therefore we see that an increase in reverse repo rate results in decrease of money supply and is a contractionary measure.
- An decrease in reverse repo rate results in increase of money supply and is an expansionary measure.
Generally there is a 1% gap between the repo rate and reverse repo rate. Reverse repo rate is always lower than repo rate.