Earlier this month, the RBI, in a surprise move decided unanimously to raise the “policy repo rate by 40 basis points to 4.40%, with immediate effect”.

What is the Repo Rate?

• The repo rate is one of several direct and indirect instruments that are used by the RBI for implementing monetary policy.
• Specifically, the RBI defines the repo rate as the fixed interest rate at which it provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
• In other words, when banks have short-term requirements for funds, they can place government securities that they hold with the central bank and borrow money against these securities at the repo rate.
• Since this is the rate of interest that the RBI charges commercial banks such as SBI and ICICI Bank when it lends them money, it serves as a key benchmark for the lenders to in turn price the loans they offer to their borrowers.

Why is the repo rate such a crucial monetary tool?

• According to Investopedia, when government central banks repurchase securities from commercial lenders, they do so at a discounted rate that is known as the repo rate.
• The repo rate system allows central banks to control the money supply within economies by increasing or decreasing the availability of funds.

How does the repo rate work?

• Besides the direct loan pricing relationship, the repo rate also functions as a monetary tool by helping to regulate the availability of liquidity or funds in the banking system.
• For instance, when the repo rate is decreased, banks may find an incentive to sell securities back to the government in return for cash.
• This increases the money supply available to the general economy.
• Conversely, when the repo rate is increased, lenders would end up thinking twice before borrowing from the central bank at the repo window thus, reducing the availability of money supply in the economy.
• Since inflation is caused by more money chasing the same quantity of goods and services available in an economy, central banks tend to target regulation of money supply as a means to slow inflation.

What impact can a repo rate change have on inflation?

• Inflation can broadly be: mainly demand driven price gains, or a result of supply side factors.
• This in turn push up the costs of inputs used by producers of goods and providers of services.
• It is thus spurring inflation, or most often caused by a combination of both demand and supply side pressures.
• Changes to the repo rate to influence interest rates and the availability of money supply primarily work only on the demand side.
• It makes credit more expensive and savings more attractive and therefore dissuading consumption.
• However, they do little to address the supply side factors, be it the high price of commodities such as crude oil or metals or imported food items such as edible oils.

Try this PYQ:

Q.If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do?

1. Cut and optimize the Statutory Liquidity Ratio
2. Increase the Marginal Standing Facility Rate
3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below:

(a) 1 and 2 only

(b) 2 only

(c) 1 and 3 only

(d) 1, 2 and 3

 

Post your answers here.

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