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In any economy, the “repo rate” is the rate of interest at which the “Central Bank” of that country gives money to the registered marketable banks or economic organizations against the government securities. In general, this is done when these commercial banks or financial institutions face any shortfall of funds.
In India, the repo rate is a monetary policy tool by which the Reserve Bank of India controls inflation. In the situation of a high rate of inflation, the central bank increases the repo rate so that the commercial banks and financial institutions do not take loans. In this way, the money supply in the market is reduced in the economy which helps control the high rate of inflation.
Inflation is known as the fall of purchasing power of the currency over a particular period. It measures the rising prices of goods and services in the economy.
Repo rate
The repo rate is the rate at which a country’s central bank loans money to commercial banks in the event of a cash shortage and RBI( the central bank of our country) lends to its clients generally against government securities for short periods.
It is short for the repurchase agreement because the short form of a repurchase agreement is called a Repo.
It is a short term secured loan. In this one-party sales it’s security to the other party and repurchases at the higher rate. This security is referred to as collateral.
In India, the repo rate was introduced in November 1997. The Monetary Policy Committee determines the repo rate in India.
In India, the repo rate averaged 5.58% from 2000 until 2022. As of April 2020, the repo rate in India is 4%.
Inflation
Inflation is known as an increase in price over a given period.
It is a broad measure of overall increases in price or increases in the cost of living in a country.
It generally occurs when the prices increase or rise and as result, it decreases the purchasing power of the money.
Another reason for its occurrence is increasing in the production costs of raw materials and wages, which as result increases the prices.
Inflation can be caused by the surge in demand for products and services can cause inflation because in these cases consumers are willing to pay more for the products.
How does inflation affect the economy?
Inflation increases the cost of living and rising prices indicate that an economy is growing fast.
People buy more than they need to avoid tomorrow’s higher price demand for goods and services.
The effect on the economy generally depends on three types of inflation.
The first example, On walking inflation increases the prices of goods and services from 3% to 10% per year.
Creeping inflation which is milder than that of walking inflation and running inflation in this type of inflation prices of goods and services rises more aggressively could be a precursor to hyperinflation.
How Repo Rate Affects Inflation
The Repo rate is a powerful arm of the Indian monetary policy that has the power to govern the country’s money supply and inflation levels.
The monetary authorities use the repo rate to keep inflation in check.
When high inflation occurs, the central bank makes a strong attempt to bring down the flow of money in the economy.
One way for the central bank to control inflation is by increasing the repo rate in the country.
This discourages the banks from borrowing from the central bank.
Banks have to pay more to borrow money, which implies that your interest rate will go up. As a result, it reduces the supply of money in the economy which helps in bringing down inflation.
When lending rates are higher, the demand for money by consumers drops. When demand is dropped it indicates that less money is being spent.
It can regulate a country’s money supply, inflation levels and liquidity.
When the repo decreases, then the low repo rate should be summarized as low-cost loans for the general masses.
When the Central bank decreases the repo rate, it expects the banks to lower their interest rate and charge a consumer rate.
The bank interest rate will change when the repo rate changes.
- There are currently prepayment penalties for floating rate housing loans
- If you have taken a fixed-rate loan when the repo rate goes down ( the base rate of the bank may reduce and hence also the loan interest rates) you will pay the same interest rate.
Conclusion
The relationship between the repo rate and inflation is inversely proportional to each other. When one increases, the other decreases.
The repo rate is known as the most important piece of equipment for the RBI or central banks to control the inflation trends.
By Increasing or decreasing the repo rate central banks control the inflation.
In the condition of inflation, the repo rate is increased by the central bank and this acts as a disincentive for the banks to borrow more from the central banks.
This results in reducing the money supply in the economy and also helps in arresting inflation.
