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How change in repo rate affects inflation and growth?

A few days before the announcement of Reserve Bank of India’s (RBI’s) monetary policy, the media is flooded with news about guesses and expectations of the market players about the rise or fall of repo rate. Why are markets so concerned about the changes in repo rates? How the changes in repo rate affects the inflation and growth in the economy?

To begin with, let us understand some terminologies.

What is Monetary policy?

Monetary policy is a policy of central bank of the country (for India, its RBI) whereby it aims to control the money supply in the country to manage inflation and promote growth.

RBI increases / decreases the policy repo rate so as to keep the operating target i.e. weighted average call rate (WACR) around the repo rate, within the interest rate corridor. This in turn influences the aggregate demand and thereby impacting inflation and growth.

What is interest rate corridor?

Interest rate corridor is a range of interest rates consisting of Marginal Standing Facility (MSF) rate as the upper band, repo rate at the center and Standing Deposit Facility (SDF) rate as the lower band of the corridor. Presently, interest rate corridor is of 50 basis points (i.e. 0.50%), with repo rate being 25 basis points below MSF rate and 25 basis points above SDF rate. At current rates, the interest rate corridor will appear as below –

MSF rate (5.15%) ---------------------------------------------------------
Repo rate (4.90%) --------------------------------------------------------
SDF rate (4.65%) ---------------------------------------------------------

What are Call, Repo, MSF and SDF rates?

  • Call rate is a rate at which banks borrow from each other without any collateral.
  • Repurchase rate or Repo rate is a rate at which banks borrow funds from RBI against the collateral of approved government securities.
  • MSF rate is the rate at which banks can borrow from RBI against the collateral of approved government securities by dipping up to 2% in SLR securities.
  • SDF rate is the rate at which banks park their surplus liquidity with RBI.

How increase in repo rate impacts inflation and growth?

When the economy is facing an inflationary trend, RBI increases the repo rate to contain the rising inflation. As the MDF and SDF rates are linked to Repo rate, with rise in repo rate, the interest rate corridor moves up.

Rise in repo rate Increases the cost of funds for banks borrowing from RBI at Repo rate Increases interest rates for loans to individuals / corporates --- Reduces demand for loans Reduces demand for goods and services Reduces prices
Increases the call rate as lender banks will demand higher rate, who can otherwise park funds with RBI at SDF rate. Thereby increases the cost of funds for banks borrowing in Call Market. Reduces investment by corporates Adversely impacts growth

When the economy is facing recession / slower growth, RBI decreases repo rate to promote growth. As the MDF and SDF rates are linked to Repo rate, with fall in repo rate, the interest rate corridor moves down.

Fall in repo rate Reduces the cost of funds for banks borrowing from RBI at Repo rate Reduces interest rates for loans to individuals / corporates --- Increases demand for loans Increases demand for goods and services Increases prices
Reduces the call rate as borrower banks will offer lower rate, who can otherwise borrow funds from RBI at repo rate. Thereby, reduces the cost of funds for banks borrowing in Call Market. Increases investment by corporates Promotes growth

RBI’s monetary policy is best suited for inflation, however, has limited impact on cost-push inflation caused by supply side factors (like shortage in supply).

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