March 1, 2024

HPAS/Allied Mains 2022 Answer Writing Challenge Day 189: Model Answer

QUESTION: What are Repo and Reverse Repo rates? Also, discuss their impact on Indian Economy. (8 marks/ 60 words)

Answer:

Repo and Reverse Repo rates are an important monetary policy tools employed by the RBI to maintain liquidity and check inflation in the economy.

Reverse Repo Rate is defined as the rate at which the Reserve Bank of India (RBI) borrows money from banks for the short term. The Reverse Repo Rate helps the RBI get money from the banks when it needs. In return, the RBI offers attractive interest rates to them.

Repo Rate: The opposite of Reverse Repo Rate is the Repo Rate, at which the banks borrow short-term money from the RBI.

The Repo Rate & Reverse Repo Rate are decided by the Monetary Policy Committee (MPC), headed by the RBI Governor. The decision is taken in the bi-monthly meeting of the Committee.

The impact of the Repo Rate on the Economy:

The repo rate has a huge impact on a nation’s economy as it is essential to regulate the cash flow in the market. The Indian monetary policy controls and regulates the repo rate depending upon the market’s liquidity and inflation cash flow. Additionally, the repo rate directly affects the borrowing capacity of banks as the repo rate is higher borrowing capacity of banks gets reduced. Repo rates play a major role in controlling inflation in the country for example if there is high inflation RBI increases the repo rate thus reducing the cash flow in the market. As the cash flow slows down production capacity and investment slows down thus pulling the inflation rate down. While on the other hand, RBI only decreases the repo rate when there is a fall in the inflation rate thus, this situation encourages banks to borrow money from RBI.

However, there are negative impacts on the repo rate as well, for example during a rise in inflation RBI increases the repo rate thus resulting in decreased cash flow leading to a fall in the production capacity of industries, and thus resulting in a price hike in necessary goods and services and also leading to unemployment. While on the other hand, RBI tries to lower the repo rates to pump more funds and thus increase the liquidity in the market. The repo rates of RBI and the interest rates on loans of commercial banks are proportional to each other If the repo rates get reduced interest rates on loans to get reduced and vice versa. As soon as the repo rates fall investors borrow a huge sum of money from the banks and invest it in multiple sectors thus leveraging the economy of the country.

The Impact of Reserve Repo rate on the Economy:

The central bank increases or decreases the reverse repo rate depending on the macroeconomic factors.

An increase in the Reverse Repo Rate provides an incentive to the banks to park their surplus funds with the central bank on a short-term basis, thereby reducing liquidity in the banking system and overall economy. In other words, the RBI gets surplus money from banks against the collateral of government securities on an overnight basis.

Whenever RBI decides to reduce the reverse repo rate, banks earn less on their excess money deposited with the Reserve Bank of India. This leads the banks to invest more money in more lucrative avenues such as money markets, which increases the overall liquidity available in the economy. While this can also lead to lower interest rate on loans for the bank’s customers, the decision will depend on multiple factors including the bank’s internal liquidity situation and the availability of other potentially less risky and equally lucrative investment opportunities.

 

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