Repo rate or repurchase rate is referred to as the rate at which the central bank (RBI) lends money to the commercial banks for meeting short-term fund requirements in order to maintain liquidity and control inflation.

Functioning of Repo Rate

Commercial banks, at times of financial crunch, seek short-term funds from the central bank of a country (RBI in the case of India) to tide over the financial crisis. For providing these funds, RBI levies interest on the amount that is lent to the commercial bank. This rate of interest is better known as the repo rate.

Repo rate is technically a repurchase agreement in which the commercial banks offer securities such as Treasury Bills to the RBI in return for short-term funds.

The banks also agree to repurchase those securities at a predetermined price.

What is Reverse Repo Rate?

RBI maintains a balance in the market by employing repo rate and reverse repo rate. The reverse repo rate, by definition, is the exact opposite of repo rate or in other words, it is the rate at which RBI borrows money from banks in the short term.

Impact of Repo Rate in Economy

Repo rate is an important component of the monetary policy of the nation, and it is used to regulate the liquidity, inflation, and money supply of the nation. Additionally, repo rate levels create a direct impact on the pattern of borrowing by the banks.

In other words, in situations of increased repo rate, the banks need to pay higher interest to RBI in order to avail funds, while in terms of lower repo rate, the cost of borrowing funds is less.

The following scenarios discuss the impact of the repo rate on the economy.

1. When the inflation rate is high: At times of high inflation in the economy, the central bank (RBI) regulates the flow of money in the economy by increasing the repo rate, which results in fewer borrowings by the businesses and the industries. The result of this increase is slowing down the money supply and investment activities in the economy, which is instrumental in controlling the inflation rate.

2. To increase liquidity in the economy: When there is a requirement of increasing liquidity in the market, RBI eases the repo rate so that businesses can borrow money for investment purposes, which results in an increased money supply in the economy. The effect of such a step is that it becomes instrumental in the growth of the economy.

Scenarios that lead to an increase or decrease in the repo rate are as follows:

Increase in Repo Rate

1. When there is a high inflation rate in the economy, and as per RBI, the condition may further surge.

2. When there is a risk of depreciation of the currency

3. When it wants to reduce any speculations that arise in areas of foreign exchange

4. The possibility of the formation of asset bubbles as a result of an excessive amount of capital formation

Decrease in Repo Rate

1. That situation in which RBI assumes that both inflation and the fiscal deficit are well controlled and there is no unlikely possibility that a demand-led price surge will be observed.

2. When the economy is showing signs of slow down and RBI looks to accelerate the economy by facilitating a more friendly monetary policy.

3. If the balance of payments situation is deemed to be normal by the RBI.

This was all about the repo rate concept, which plays an important role in the monetary policy of RBI. For more such interesting concepts on Economics for Class 12, stay tuned to BYJU’S.

Also See:

• Money and Banking

• Money Creation by Banking System

• Difference Between Central Bank and Commercial Bank

• Functions of the Central Bank

• Functions of Commercial Banks