For almost two years now, our economy has been sailing on tumultuous seas, unsteady and uncertain. So how exactly is the government trying to keep it afloat? One answer lies in our central bank’s monetary policy, and how it regulates interest rates.
Banks are usually where you borrow money from, but believe it or not, banks sometimes find themselves in need of some quick cash too. This can be due to a little liquidity shortage (read: someone wants their money back but the bank doesn’t have enough cash on hand right now) or in order to meet a mandatory reserve requirement (read: the bank needs to hold some cash in reserve precisely to avoid the above-described scenario). But who can a bank borrow from? Why, the Reserve Bank of India, of course – the central bank that calls itself a ‘banker to banks’.
Naturally, there’s an interest rate at which the RBI lends money. This rate is called the repo rate. ‘Repo’ stands for ‘repurchase option’ or ‘repurchase agreement’. How it works is this: Say a bank needs a one-day loan. The RBI is willing to lend, if the bank provides a collateral. This can be any approved form of security, such as government bonds or treasury bills. So the bank hands over some securities in exchange for the money, and promises to buy back or ‘repurchase’ those securities at a predetermined price at the end of the loan period. Essentially, the repo is a purchase and a repurchase bundled together in a trenchcoat in the disguise of a loan. The difference between the repurchase price and the original amount borrowed makes up the interest paid by the bank. And the rate of this interest? Is the repo rate fixed by the RBI. Conversely, the reverse repo rate is the rate at which the RBI borrows from banks in a similar fashion.
These rates are important tools of monetary policy, because they influence general interest rates and ultimately inflation. If banks have to borrow at a higher rate, they’d have to lend at a higher rate, too. So an increase or decrease in the repo rate significantly affects the interest rate that you or I would be charged on our loans.
Lower interest rates are good for economic growth. Lower interest means individuals, industries and businesses are all more likely to borrow and spend, thus increasing money supply in the market and stimulating growth. Right now, the repo rate is as low as 4%, and has been so since May 2020, in an attempt to mitigate the impact of the pandemic on our economy. The latest concerns with the emergence of Omicron have pushed back any plans to hike up the rate.
Of course, too much money in the market can lead to undesirable levels of inflation, so the repo rate needs to be maintained within limits on both sides. Inflation can also be kept in check by increasing the reverse repo rate, thus encouraging banks to deposit their excess funds in the central bank and earn returns. This leaves less money for the public to borrow, thus restricting cash flow.
And that’s how our monetary policy uses two simple but powerful tools to keep the economic ship from tipping over.