QUES . Distinguish between Repo Rate and Reverse Repo Rate. Explain their relevance in the present context of inflation. UPSC IES/ISS EXAM 2022 General Studies. 200 Words. 5 Marks.
HINTS:
Repo rate and reverse repo rate are two important policy tools used by the central banks to manage the liquidity in the market and control inflation.
What is Repo Rate?
Repo rate is the rate at which the central bank lends money to commercial banks against government securities. In other words, when commercial banks face a shortage of funds, they can borrow from the central bank by pledging government securities as collateral.
The repo rate determines the cost of borrowing for commercial banks and hence affects the interest rates in the economy.
An increase in the repo rate leads to a decrease in the money supply in the market, which, in turn, reduces inflation. On the other hand, a decrease in the repo rate leads to an increase in the money supply in the market, which stimulates economic growth.
What is Reverse Repo Rate?
Reverse repo rate is the rate at which the central bank borrows money from commercial banks by selling government securities. In other words, when the central bank wants to suck out excess liquidity from the market, it borrows money from commercial banks at the reverse repo rate, which reduces the money supply in the market.
An increase in the reverse repo rate leads to an increase in the interest rates in the economy, which, in turn, reduces inflation. On the other hand, a decrease in the reverse repo rate leads to a decrease in the interest rates in the economy, which stimulates economic growth.
Key Differences Between Repo Rate and Reverse Repo Rate
Borrower and Lender
In the case of the repo rate, the lender is the RBI while the borrower is the commercial bank. Whereas in the case of Reverse repo rate, the opposite holds true, the lender is the commercial bank and the borrower is the RBI.
Importance
Repo rate helps RBI manage short-term deficiency of funds. Reverse repo rate decreases and controls the overall flow of money in the economy.
Rate of Interest
Repo rate remains higher than reverse repo rate. Whereas, reverse repo rate remains less than the repo rate.
Applicable Interest
In the case of the repo rate the interest charge is defined in the repurchase agreement between the RBI and the commercial bank. Whereas in the case of Reverse repo rate, the interest charge is defined in the reverse repurchase agreement between the RBI and the commercial bank.
Mechanism
In the case of the repo rate, commercial banks get money from the RBI when the latter purchases government bonds from the former. Whereas in the case of Reverse repo rate, the RBI acquires funds from commercial banks through the deposit of their excess funds and the bank charges interest on this deposit.
In case of a high interest rate
With high repo rate , the cost of funds goes up, making loans more expensive. With high reverse repo rate, the supply of money in the economy reduces since the excess funds of commercial banks are deposited with the RBI.
In case of a lower interest rate
With low repo rate the cost of the funds reduces for commercial banks leading to lower interest rates on loans.
With low reverse repo rate, more money is supplied in the economy with lower interest rates as banks lend more and park less with RBI.
Relevance of repo rate and reverse repo rate in inflation
In the present context of inflation, both the repo rate and reverse repo rate are relevant. If inflation is high, the central bank may increase the repo rate to reduce the money supply in the market and hence reduce inflation.
Similarly, the central bank may increase the reverse repo rate to suck out excess liquidity from the market and hence reduce inflation. However, if inflation is low, the central bank may decrease the repo rate to stimulate economic growth, and it may decrease the reverse repo rate to increase liquidity in the market.
