Reserve bank of India helps commercial banks during a shortage of funds. It lends money to banks at a rate, which is called the Repo rate. The relationship between banks and repo rate is proportional to each other. When the repo rate reduces, the banks lend money at a cheaper rate. But if the rate increases, the RBI lends money at a higher rate, therefore banks also lend money to their potential borrowers at a higher interest.
How does the Repo Rate affect the economy?
Repo rate is a powerful tool of monetary policy that regulates the supply of money, level of inflation, and liquidity in the economy of the country. Monetary authorities also use it to control inflation. Additionally, the repo rate has a direct relationship with the cost of borrowing that banks have to bear. When the market suffers from inflation, the central bank increases the repo rate. When commercial banks want to borrow money from the central bank, this acts as a discouragement for them. The action results in a reduction in the supply of money in the economy and arrests inflation. The central bank holds a contradictory position at the event of downfall in case of pressure arises from inflation.
How do banks decide Repo Rate?
The preamble of RBI states that the primary objective of the monetary policy of India is to ‘maintain the stability of price’ while keeping the objective of constant growth in mind.
Before taking the call, the central bank of India assesses a few factors, such as the current trend of inflation, fiscal projections, as well as fiscal deficit. The encumbrance of making the decision depends on a team of five members of the Apex bank. This team comprises both officials from the Reserve bank of India as well as external experts. The Appointments Committee of the Cabinet decides the names of external experts. These experts serve the position for four years. After that, they are not eligible for re-appointment.
MPC (Monetary Policy Committee) of all these reputed members presides for a period of three days and come up with a decision that is preferred by the majority. Earlier, the governor of RBI had this system. But this is now replaced by the MPC framework. While a committee advises on the decision related to monetary policies, the central bank welcomes its recommendations with open arms.
RBI is bound to publish a monetary report half-yearly. The report should have a detailed explanation of the cause of inflation. It should also provide a brief forecast of the coming six to eight months. In case the central bank fails to meet the targeted inflation, it has to present the reason for the failure. Along with that, it has to provide remedial actions. It should provide an estimated time period within which the target of inflation shall be achieved. MPC also tries to ensure that the inflation target decided by the government and RBI is fulfilled.
However, the Repo rate is a crucial factor when it comes to the borrowings of the loan. All the decisions taken by the monetary authorities play a significant role in the economy.