How Change in Repo Rate Impacts the Economy

The Reserve Bank of India (RBI) recently hiked the repo rate to 4.90% in its monetary policy meeting. The reason was simple – to curb the red hot inflation that’s been on a rise lately.

However, this equation isn’t as simple as it looks to be. Repo rates have wide ranging implications on the economy and most of the monetary policy decisions revolve around it.

So, let’s understand what is a repo rate and how an increase or decrease in it can have implications for various sectors and the economy at large.

What Is Repo Rate?

Repo rate is the rate at which the central bank of a country (RBI in the case of India) lends money to commercial banks or financial institutions. It lends money against government securities.

Say a private bank is in need of funds and wants to borrow Rs 10 crore. It can go to the RBI and borrow these at the prevailing repo rate set by the RBI. If the repo rate is 4.9%, the bank will have to pay 4.9% on the Rs 10 crore borrowed as an interest until the funds are returned to the central bank.

And apart from the above, repo rate is also used by monetary authorities to manage and control inflation.

Here’s how:

Central banks increase repo rate to curb inflation. A rise in repo rate or the borrowing rate discourages banks to take funds from the central bank. This also means that banks will have less funds to disburse as loans. And this ultimately reduces the money supply in the economy and thus helps in controlling inflation.

A higher interest rate also means more investors buying government bonds and interest-rate products in order to earn higher returns. And with more people opting to park their funds in fixed deposits (FDs) and government bonds, more money is removed from circulation in the economy.

Low money supply leads to greater demand for the currency, which further leads to an increase in its value and helps in lowering inflation.

On the flipside, a hike in repo rate makes public borrowings such as home and car loans costlier. This is because banks pass on the rise in repo rate by the RBI to customers in the form of higher interest costs on loans.

The RBI reduces the repo rate when it needs to infuse more money into the market and support economic growth.

A fall in interest rates encourages consumers to spend more.

Banks can borrow funds from the RBI at lower cost and this further helps them disburse out loans to customers at lower rates. This further leads to increased interest for loans from consumers at cheaper rates. This is especially true when it comes to home loans, which eventually benefits the real estate sector and the economy at large.

Apart from general borrowers, lower interest rates are also a huge boost for the industrial sector.

As we saw earlier, lower interest rates make borrowing cheaper and this allows companies to expand businesses, which in turn generates more employment and job opportunities and also contributes to increased economic growth.

Moreover, it results in commodities becoming cheaper and ultimately benefiting the end consumer.

However, low-interest rates also mean investors earning a lower return on FDs as banks reduce FD interest rates during a low interest rate environment.

So, those were some of the implications a change in repo rate can have for individuals, banks and financial institutions, companies, and the economy at large.

Interesting, isn't it?

But do you think that solely raising repo rate is enough to get a hold of rising inflation?

And should the RBI hike rates in its upcoming policy meetings to lower inflation?

Let us know your thoughts in the comments section below!

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Sources: Kotak Securities, Economic Times, India Today, Bank Bazaar