A Repo Rate
, also known as Repurchase Option Agreement Rate
is an interest rate at which commercial banks borrow money from the Central Bank
of a country in case of shortage of funds.
Generally, a central bank provides only secured and short term loans to the commercial banks by keeping government securities as collateral and also at the same time commercial banks promise to repurchase these securities by the end of the loan period.
In other words, commercial banks have to sell its government securities (central bank approved securities) to the central bank with a promise to repurchase those securities later to get credit. Therefore, it (Repo Rate) is also known as a sale purchase agreement rate.
Short term loans refer to the period of either one day (overnight) or seven days (called as term loans).
What is Reverse Repo Rate?
A Reverse Repo Rate, also known as Resell Option Agreement refers to an interest rate which is paid by the central bank on the funds-deposits of commercial banks, in case of surplus funds.
Generally, the commercial banks deposit its surplus funds to the central bank by purchasing government securities with a promise to resell those securities later on the maturity date.
Obviously, the central bank will pay some interest to the commercial banks. In fact, this interest rate is called Reverse Repo Rate.
Let me explain it with an example.
Suppose State Bank of India (SBI) has to borrow Rs 10 crores from the Reserve Bank of India (RBI), the central bank of India. Assume the current repo rate is 6% and the reverse repo rate is 5.75%.
Now the RBI keeps the government securities worth Rs 10 crores as collateral and provides a loan of Rs 10 crores to SBI at the rate of 6% per Anum for the period of one day (overnight).
In other words, SBI sells its government securities worth Rs 10 crores to RBI with a promise to repurchase the same securities after one day (overnight).
Thus after one day SBI pays back Rs 10 crores with interest @ 6% (10 crores + 16,438) to RBI and repurchase it’s government securities.
Impact of Repo Rate and Reverse Repo Rate on Inflation:
The central bank of a country maintains the inflation rate by adjusting the repo rate and reserve repo rate.
If the rate of inflation in a country (say India) is higher, the central bank (RBI) will increase the repo rate and reserve repo rate and hence the interest rate of commercial banks also increase.
This means the different loans become costly. Thus the supply of money reduces in the market and the expanses of people will also reduce. Therefore, people will avoid taking loans.
This leads to less demand for goods and services and hence prices will reduce as well. Thus inflation rate is reduced by increasing Repo rate and reserve repo rate.
How the Repo Rate and Reserve Repo Rate effect on Growth Rate?
The central bank increases the money supply in the market to improve growth rate. Therefore, to increase the money supply the central banks reduce the repo rate and reserve repo rate.
Suppose if the repo rate and reserve repo rate is reduced, the commercial banks also reduce their interest rates and hence the different loans will become cheaper.
Thus people have more money for their expenses and hence the demand for goods and services raise. This results, a significant increase in prices and therefore there would be an increased growth rate.