Repo Rate is an important monetary policy tool in RBI’s armour. However, before we get into the details of the Repo Rate, we must understand inflation and its impact on the economy.
What is inflation? Inflation refers to a situation when the price of goods and services increases continuously, thereby causing the purchasing power of money to fall. When inflation continues to increase unabated, commodities become expensive, thereby making them unaffordable to the common man. Thus, when inflation rises beyond an acceptable level, the Reserve Bank of India jumps into action and the Repo Rate is the monetary policy tool that it uses to bring inflation under control.
So, what is the Repo Rate and how does it help control inflation? The term Repo refers to Repurchasing Agreement or Repurchase Option. The repurchase agreement is an agreement that makes it binding for the borrowing party to repurchase the securities against which they had availed of funds before an agreed date. The interest charged for such borrowings is called the Repo Rate.
In the case of the Reserve Bank of India and scheduled commercial banks and lenders, the latter can avail of funds from the central bank of the country for a short term by pledging government-approved assets, such as cash, gold, government bonds, etc. The borrowing bank or lender must repurchase these pledged assets before a pre-agreed date after paying the interest due to the RBI. Consequentially, the interest rate that the RBI charges for such borrowings is called the Repo Rate.
So, how does the Repo Rate affect inflation?
When inflation rises beyond an acceptable level, the Reserve Bank of India, which is responsible for ensuring the smooth working of the Indian economy, acts by increasing the Repo Rate. Banks and lenders, thus, have to pay a higher rate of interest on their borrowings to the RBI. As a result, these banks and lenders now charge a higher rate of interest on various financial products they offer to their clients. Thus, a Repo Rate hike makes loans expensive.
Individuals who understand the banking systems and the various external factors that affect it and its products understand that one should not borrow money after a Repo Rate hike. Thus, an increase in the Repo Rate reduces the demand for loans, which in turn, dampens the purchasing power and the flow of funds within the economy. This helps bring inflation under control.
Alternatively, when economic growth slumps, the RBI acts by reducing the Repo Rate. Thus, borrowing parties have to pay a lower rate of interest to the RBI while borrowing funds. This, in turn, allows banks and commercial lenders to offer loans to clients at lower home loan interest rates. Thus, a reduction in the Repo Rate makes loans cheaper and increases the demand for them. Consequentially, people’s purchasing power increases and so does the flow of money within the economy. This helps revive the economy.
How Do Repo Rate Changes Affect the Common Man?
The common man must keep themselves informed about Repo Rate changes for changes in the Repo Rate directly affect their purchasing power.
When the Reserve Bank of India increases the Repo Rate, loans become expensive. Individuals repaying a home loan or a loan against property on floating interest rates find that their EMIs have gone up. Further, after a Repo Rate hike, loans become expensive and therefore, one must refrain from availing themselves of a loan after the RBI increases the Repo Rate, i.e. if another hike is not expected. However, Repo Rate hikes are often associated with better returns on standard and fixed deposits. On the other hand, a decrease in the Repo Rate brings relief to the common man by making loans cheaper. When the Repo Rate is low, people should avail themselves of loans to fulfil their life goals.
While we are on this subject, let us also discuss the difference between the Repo Rate and Bank Rate as borrowers often get confused between the two.
Bank Rate vs. Repo Rate: Know the Difference
The bank rate is the rate of interest that the RBI charges banks and commercial lenders in the case of long-term loans availed of without pledging security. Repo Rate loans are meant to handle short-term liquidity crunches. These loans cannot be availed in the absence of government-approved securities.
The Bank Rate is always lower than the Repo Rate. The current Bank Rate is 5.15% whereas the current Repo Rate is 6.50%.