change in repo and reverse repo

Posted: September 20, 2010 in economy
Tags: , , , , , , ,
Reserve Bank of India Headquarter in Mumbai

Reserve Bank of India Headquarter in Mumbai

the reserve bank of India has increased the repo and reverse repo rates.the repo rate has been hiked by 25 bps and the reverse repo has been increased by 50 bps.the new repo rate is 6% and the reverse repo is 5%. this decision of the RBI has invited a lot of criticism as well as appreciation.

let me first explain the meaning of repo. repo is the rate (of interest) at which the central bank (RBI) funds the other commercial banks of the country. the commercial banks borrow money from the central bank for their operations. for this they have to pay an interest to the RBI. similarly the RBI may also borrow money from the commercial banks. the rate at which the RBI takes the money is called the reverse repo. you must know hat reo is also called as bank rate. now the question arises is what is BPS? BPS stands for basic point system. it is used for denoting changes in interest rates etc.

what is the value of 1 bps?

1 bps is equal to 1/100 of 1%

i.e. 100bps is equal to 1%change.

so when we say that repo rate has been increased by 25bps, it means 0.25%. similrly the reverse repo has gone up by 50 bps or 0.50%.

now that you understand the meaning of repo and reverse repo, you should also know what it it used for and why is it so important that it shows up in the news headlines. bank rate (or repo) is an important tool for credit control. credit control means the amount of money supply in the economy. in other words it is the amount of money with the people in the economy. whenever the money in hands of the people has to be checked or lowered, the repo is increased and vice versa.

how does repo control money supply?

the mechanism of repo is easy to understand. when the central bank increases the repo, the commercial banks would have to pay more interest for the borrowed money. thus to make up with the increased interest burden, they would charge their customers with a higher amount of interest on loans issued to them. it means the banks would grant loans at a higher rate of interest to avoid losses. consequently the customers would borrow less amount of money. thus the amount of money flowing in the economy would decrease.

on the other hand, if repo is reduced then the loans would become cheaper for the people. they would be ale to afford more borrowings due to the reduced interest rates. thus the money supply in the economy will increase.

why is credit control important?

well to understand this first you need to know about inflation and its threats to our economy social welfare. gradual rise in the prices of goods and services over a period of time is called inflation. there are various debates related to inflation. some economist say that inflation to some extent is essential to the economic growth of a country. i wont be discussing the details of inflation. what we need to know that excess inflation is bad for the economy. when the prises of goods (specially the essential commodities) rise a lot over a period of time the people face various problems. there is shortage of goods in the market and symbolizes low supply in the economy. in short high inflation rate is not the characteristic of a healthy economy.

inflation occurs when there is a lot of demand in the market and not enough supply to cope with it. when people have a lot of money with them, the spend more th usual. thus the demand in the market rises. the supply however takes time to increase and might not respond well to the sudden change in demand. as a result a shortage or gap is created in the market. and due to this shortge the prices of goods go up. this goes on over a period of time causing inflation.

so when the RBI (which is responsible fro checking inflation) in the economy reduces the money supply in the economy, people demand less. the overall demand comes down to meet the supply in the market. thus a balance strikes between the demand and supply. this causes the prises to come down and stabilize. thus inflation is checked.

what does RBI’s recent decision imply?

the hike in repo and reverse repo rate implies that from now onwards loans will be more expensive. there will be reuction in consumption by the people. this is expexted to control inflation to some extent as it remains the major cause for such a decision.

i hope that now you have a better understanding of repo and its impact on our economy….

  1. akanksha says:

    i am pretty happy with this decision.. it was a dire need to control the inflation.. though inflation is important to some extent, but in a country like ours, where there is a major disparity between the income groups.. it’s unfair towards the people with fixed salary and lower income groups….
    nice article.. ab ja kr mere ko repo rate samajh main aya…lolzzz

    waiting for the next post!

  2. Interesting information, thank you for sharing.

  3. the information on this article is really 1 of the most beneficial substance that I’ve at any time occur throughout. I really like your submit, I will appear again to examine for new posts.

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