RBI controls Liquidity and Inflation by Repo Rate and Reverse Repo Rate

by khalid on 18/02/2011 · 0 comments

Reserve Bank of India controls liquidity and inflation by changing the value of repo rates and reverse repo rates.

Rapo rates is nothing but repurchase rate. This is the rate at which a commercial bank borrow from RBI. At the time commercial banks are short of funding due to gap between demand (loans) and how much they have on hand to lend, they go to Reserve Bank for their need of short funding.

Reverse Repo Rate is the exact opposite of repo rate. This is the rate at which RBI borrows money from the banks (or banks lend money to the RBI). The RBI uses this tool when it feels there is too much money floating in the banking system.

At the time RBI feels that the liquidity in the system is high due to which inflation increased and wants to make money more expensive it increases repo rate (The rate at which it lends to banks). Similarly if RBI feels there is a liquidity crunch in the market and wants to make it cheaper for banks to borrow money it reduces repo rate.

If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest.

As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk). Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy. Liquidity is contained in this way.

Reverse repo rate signifies the rate at which the Reserve Bank absorbs liquidity from the banks, while repo rate signifies the rate at which liquidity is injected.

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