Model Answer
0 min readIntroduction
The Reserve Bank of India (RBI) employs various monetary policy tools to regulate the money supply and credit in the economy, thereby influencing inflation and economic growth. Two of the most important tools are the repo rate and the reverse repo rate. These rates act as benchmarks for commercial banks and significantly impact borrowing costs for individuals and businesses. Understanding these rates is crucial for comprehending the dynamics of the Indian financial system, especially in the context of fluctuating interest rates and their effect on loan repayments like Equated Monthly Installments (EMIs).
Repo Rate: Definition and Mechanism
The repo rate (repurchase rate) is the rate at which the RBI lends money to commercial banks against the security of government securities. When banks need short-term funds, they borrow from the RBI by selling these securities with an agreement to repurchase them at a later date at a predetermined price. Essentially, it’s a short-term borrowing option for banks.
- A higher repo rate makes borrowing more expensive for banks.
- This discourages banks from borrowing from the RBI, reducing the money supply.
- Reduced money supply can help control inflation.
Reverse Repo Rate: Definition and Mechanism
The reverse repo rate is the rate at which the RBI borrows money from commercial banks. Banks park their surplus funds with the RBI, earning interest. This is the opposite of the repo rate.
- A higher reverse repo rate incentivizes banks to deposit more funds with the RBI.
- This further reduces the money supply in the economy.
- It also provides a floor for short-term interest rates.
Impact of Repo Rate Changes on EMIs
Changes in the repo rate have a direct impact on the EMIs of borrowers, particularly those with loans linked to external benchmarks like the Marginal Cost of Funds based Lending Rate (MCLR) or the Reserve Bank of India’s policy repo rate.
- Transmission Mechanism: When the RBI increases the repo rate, banks’ cost of borrowing increases. Banks then pass on this increased cost to their customers by raising lending rates.
- EMI Increase: Higher lending rates translate into higher interest rates on loans, leading to an increase in EMIs. Conversely, a decrease in the repo rate leads to lower lending rates and reduced EMIs.
- Floating vs. Fixed Rate Loans: The impact is most pronounced on loans with floating interest rates, as these rates are directly linked to the benchmark rate. Fixed-rate loans are not immediately affected, but new loans will be offered at the revised rates.
Example: If a borrower has a home loan of ₹50 lakh with a 20-year tenure at an interest rate of 8%, a 0.25% increase in the repo rate could lead to an increase of approximately ₹750-₹800 in the monthly EMI. (This is an approximate calculation and actual impact may vary based on bank policies).
| Feature | Repo Rate | Reverse Repo Rate |
|---|---|---|
| Definition | Rate at which RBI lends to banks | Rate at which RBI borrows from banks |
| Impact on Money Supply | Increases money supply (when lowered) | Decreases money supply (when raised) |
| Borrower/Lender | RBI is lender, Banks are borrowers | RBI is borrower, Banks are lenders |
Conclusion
In conclusion, the repo rate and reverse repo rate are pivotal tools employed by the RBI to manage liquidity and inflation within the Indian economy. Changes in the repo rate directly influence the cost of borrowing for banks, which subsequently impacts the EMIs paid by borrowers. Understanding this transmission mechanism is essential for both policymakers and individuals navigating the financial landscape. The RBI’s strategic adjustments to these rates are crucial for maintaining economic stability and fostering sustainable growth.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.