You must have heard or seen people saying “RBI has increased
the interest rate.” Or “RBI should cut the interest rate to boost the economy.”
Do you know what does it mean? how RBI cuts interest rates? and what are the
impacts of it on our economy?
Every country has central bank which monitors the inflation
and growth of that country. In India, we have Reserve Bank of India (RBI) for
this.RBI controls the interest rates and liquidity i.e. supply of money in the
economy. Growth and Inflation are managed by RBI by managing interest rates and
liquidity. RBI uses these tools for it.
Repo rate is the rate at which the central bank of a country
(Reserve Bank of India in case of India) lends money to commercial banks (eg.
SBI, ICICI, PNB) in the event of any shortfall of funds.
A repo rate short for repurchase agreement in which
commercial banks borrow from the RBI in return of the collateral for the short
term government securities. Commercial bank sells securities to RBI and agrees
to repurchase these securities after a certain period of time at a pre-determined
price. Therefore, the interest rate used in these securities for repurchase is
known as a repo or repurchase rate.
Repo rate is used to control the demand supply of money in
So if there is a high inflation in the economy, RBI would
increase the repo rate. Now cost of borrowing of commercial banks would increase.
The less the loans, the less funds would be disbursed as loans. Which means
less money in the hands of the people which would in turn reduce the demand?
And due to reduction in demand, prices would come down and ultimately inflation
will be in control.
But if there is depression in the economy, RBI would decrease
repo rate. Now commercial banks have more money for providing loans to public.
Due to it demand will increase and economy will grow.
High repo rate leads to depression in economy and lower repo
rate leads to inflation.
Reverse Repo Rate:
Reverse repo is the exact opposite of repo. In a reverse repo
transaction, commercial banks buy government securities from RBI and lend money
to it for earning interest. Reverse repo rate is the rate at which RBI borrows
money from banks.
The Reserve bank uses this tool when it feels there is too
much cash floating in the system. An increase in the reverse repo rate means
that the banks will get a higher rate of interest from RBI. Due to this, banks
prefer to lend their money to RBI instead of lending it others because lending
to RBI is comparatively less risky.
It is also known as discount rate. It is the rate at which
commercial banks borrow money from RBI due to anticipated shortage of funds. Such
lending transactions do not involve any collateral.
Bank rate has a direct impact on the lending rates offered by
commercial banks to their clients. The lending rate charged to commercial banks
is passed down to the customers who borrow loan from these banks. If the bank
rate is high, the rate offered by a commercial bank to its clients will also be
higher, and if bank rate is low, the lower rate will be charged by commercial
banks on the loan issued to the clients.
Bank Rate VS Repo Rate:
The bank rate is charged to commercial banks against the loan
given to them by RBI, whereas, the repo rate is charged for repurchasing the
No securities are involved in a bank rate. But a repurchase
agreement uses securities as collateral, which are repurchased at a later date.
As the collateral is involved in repurchase agreement, it is
comparatively lower than the bank rate.
Repo rate is typically used to cater the short
term fund requirements of businesses. So, when RBI increases the repo
rate, Liquidity reduces in the economy. However, it doesn’t affect the market
rate of interest, because commercial banks bear the additional load of interest
to secure their customer base. But when RBI increases the bank rate, it
directly affects the lending rate offered to customers, discouraging them from
taking loans and reducing the overall growth of economy. Repo rate might leave
an impact on the investment amount, but its impact will not be as direct and immediate
as a bank rate.
Cash Reserve Ratio (CRR):
Cash reserve ratio is the amount of funds that the banks have
to keep with RBI. Say a bank's deposits increase by Rs 1 lakh and if the cash
reserve ratio is 9%, the banks will have to hold Rs. 9 thousands with RBI and
the bank will be able to use only the balance 91 thousands for investments and
lending, credit purpose.
If the RBI increases the CRR, the available amount with the
bank reduces. RBI uses the CRR to curb excessive money from the system.
Commercial banks are required to maintain with the RBI an average cash balance,
the amount of which shall not be less than 3% of the total of the Net Demand
and Time Liabilities (NDTL) on a fortnightly basis and the RBI is empowered to
increase the rate of CRR to such higher rate not exceeding 20% of the NDTL.
Statutory Liquidity Ratio (SLR):
SLR is the percentage of Demand and Time Maturities that
banks need to have in any or combination of cash, gold or unencumbered approved
securities. High SLR forces commercial banks to maintain a larger proportion of
their resources in liquid form and thus impairs their capacity to grant loans
and advances which helps in inflationary conditions.
The minimum limit of SLR is 24% and maximum limit of SLR is 40%.
This restriction is imposed by RBI on to make funds available to customers on
demand as soon as possible.
CRR vs. SLR:
Both CRR and SLR are tools in the hands of RBI to regulate
money supply in the hands of banks that they can pump in economy.
SLR controls the bank’s leverage in pumping more money into
the economy. On the other hand. CRR is the percentage of deposits that the
banks have to maintain with the Central Bank to reduce liquidity in economy.
Thus CRR helps in controlling liquidity in economy while SLR regulates credit
growth in the country.
The other difference is that to meet SLR, bank can use cash,
gold or approved securities whereas with CRR it has to be only cash. CRR is
maintained in cash form with RBI, whereas SLR is the money deposited in