When does RBI hike interest rate?
Reserve Bank of India (RBI) is an apex bank or central bank in India. It controls the functioning of all other the banks in India to ensure a healthy economic system. Periodically, RBI reviews these norms, rates, and ratios and takes corrective action in its monetary policy update to stabilize the economy. One of these actions is Changes in Repo Rates and Reverse Repo Rates and these changes primarily impact the liquidity in the economy and help to correct inflation of the country.
What is Repo Rate?
Repo rate is a rate at which the central bank of any country (i.e. RBI in India) lends money to commercial banks, in case of shortfall of funds. So, when banks are short of funds, they borrow funds from RBI at the repo rate. It is a benchmark rate for short-term lending by RBI and is also known as “Bank Rate”. In short, the repo rate is a rate at which liquidity is injected in the system.
What is the Reverse Repo Rate?
Reverse Repo Rate is a rate at which RBI borrows money from other banks for short term. This is the rate at which the liquidity is absorbed from the banks.
Why does RBI hike interest rate?
Generally, RBI hikes the repo rate to control the inflation.
Similarly, RBI hikes the reverse repo rate to absorb the excess liquidity in the market.
Inflation is an indication that people have more money with them to spend. It is also an indicator of a growing economy. Hence inflation and liquidity in the market are strongly co-related.
What happens when the Repo rate is hiked?
When the repo rate is increased, banks find it costlier to borrow money from RBI. In turn, banks too increase the interest rate of loans lent to their customers.
With the increasing borrowing rate, customers are discouraged to borrow money from banks. This reduces the availability of funds with the customers.
At the same time, as banks find it difficult to borrow at repo rate, they may increase their deposit rates to attract deposits.
All this ultimately reduces liquidity in the market. With less money available with end users, they get less money to spend. This controls inflation.
What happens when Reverse Repo rate is hiked?
With the increase in Reverse Repo rate, the banks get more interest on deposits with RBI. This encourages banks to keep money with RBI rather than with anyone else. As, deposits with RBI are always safe and with higher Reverse repo rate, the interest income earned by banks is more.
As a result, the excess liquidity available with banks is absorbed. The banks will have less money available with them to lend to customers. This in turns reduces overall liquidity with customers. As a result, customer’s spending power also reduces, and inflation is controlled.
Therefore, when RBI wants the contraction of credit, it increases Reverse Repo Rate.
Similarly, RBI reduces Repo rate to increase the liquidity and the inflation.
In short, a rate hike is done to:
- decrease the inflation
- to reduce the liquidity in the market and
- when the economy is growing at a rapid rate.
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