Every day people go to commercial banks (such as the State Bank of India) either to deposit their savings or to get a loan, for example for a car or a house.
On their savings/deposits, the bank pays them interest at a certain rate. On the loans, the bank charges them interest at a certain rate. As a general rule, the interest rates charged by banks on loans are higher than the interest they pay on deposits.
How does a bank decide the repo rate?
A key deciding factor – although not the only one – is the interest rate that commercial banks themselves pay (or get) when they borrow (or deposit) money from (or in ) the Reserve Bank of India.
The interest rate that the RBI charges when commercial banks borrow money from it is called the repo rate. The rate of interest that the RBI pays commercial banks when they place their excess cash with the central bank is called the reverse repo rate. Since RBI is also a bank and has to earn more than it pays, the repo rate is higher than the reverse repo rate. Currently, the repo rate is 4% and the reverse repo rate is 3.35%.
How does the repo rate affect the economy?
By using these two rates, the RBI sets the tone for all other interest rates in the banking system and, through this, the wider economy. For example, when the RBI wants to encourage economic activity in the economy, it cuts repo rates.
This allows commercial banks such as the SBI to lower the interest rates they charge (on their loans) as well as the interest rate they pay on deposits. This, in turn, incentivizes people to spend money, because keeping their savings in the bank now pays a little less, and businesses are incentivized to take out new loans for new investments, because new loans also cost a little cheaper.
It is for this reason that repo and reverse repo rates are often referred to as the “benchmark” interest rates in the economy.
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