Reverse Repo Rate definition: The Reverse Repo Rate is an important Monetary Policy tool used by the Reserve Bank of India (RBI) to control liquidity and inflation in the economy.
Reverse Repo Rate definition: The Reverse Repo Rate is an important Monetary Policy tool used by the Reserve Bank of India (RBI) to control liquidity and inflation in the economy. So, what is Reverse Repo rate? The interest rate at which the RBI borrows money from banks for the short term is defined as Reverse Repo Rate. The Reverse Repo Rate helps the RBI get money from the banks in times of need. In return, the RBI offers attractive interest rates to them. The banks also voluntarily park excess funds with the central bank as it provides them with an opportunity to earn higher interest on surplus money lying idle.
What is the difference between repo rate and reverse repo rate?
- Under the Reverse Repo Rate, banks deposit excess funds with the RBI and earn interest for it.
- The opposite of Reverse Repo Rate is the Repo Rate, at which the banks borrow short-term money from the RBI.
How Reverse Repo Rate controls the flow of money into the system
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. In short, the RBI absorbs surplus money from banks against the collateral of eligible government securities on an overnight basis. This happens under the Liquidity Adjustment Facility or LAF under the Reverse Repo Rate.
Why is Repo Rate higher than Reverse Repo Rate?
Banks can park their money with the RBI at a lower interest rate than the Repo Rate or Repurchase Rate. The Reverse Repo Rate is lower than the Repo Rate. The spread between the two is the RBI’s income. RBI earns more on what it lends to banks than its expense on what it borrows from the banks. Since RBI can’t offer higher interest on deposits and charge lower interest on loans, Repo Rate is higher than Reverse Repo. Also, the Reverse Repo Rate is generally kept lower to discourage banks from keeping surplus funds with RBI as against lending them to individuals and businesses. Both the primary tools in RBI’s Monetary and Credit Policy work in an opposite manner.
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Who decides Reverse Repo Rate?
In India, the current Reverse Repo Rate is decided by the RBI’s Monetary Policy Committee* (MPC), headed by the RBI Governor. The decision is taken in the bi-monthly meeting of the Monetary Policy Committee*.
How Reverse Repo rate impacts home loans
When RBI increases the Reverse Repo Rate, banks may increase home loan lending rates since it is more profitable to invest in low-risk government-backed securities as against lending money to people in the form of home loans. The home loan rates may fall when the Reverse Repo Rate goes down.
How is Reverse Repo Rate used to control inflation?
RBI increases the Reverse Repo Rate so as to incentivise the banks to deposit surplus funds with it to earn higher interest on them. It reduces the supply of money in the system, thus controlling inflation. Similarly, when the RBI has to stoke inflation a little, it may choose to cut Reverse Repo Rate and Repo Rate, which frees up the money supply.
How Reverse Repo Rate impacts the strength of rupee/currency?
Higher Reverse Repo Rate reduces the money supply in the market as the banks park their surplus cash with the RBI to earn attractive returns as against lending to individuals and businesses. It reduces the supply of money in the system, thereby boosting the strength of the rupee.
*As per the trends prevalent at the time of publishing