The Repo Rate is a very important tool that RBI uses to its best advantage. Before we elaborate on how RBI uses this tool, let us understand what is Repo Rate.
Every bank and commercial lender in India that is recognized by the Reserve Bank of India must maintain certain percentage of deposits in the form of cash, gold or other government-recognized securities before it can start lending money to borrowers. The RBI has made this rule for many reasons. The concept of Repo Rate allows RBI to control inflation and push economic growth within the country. It also saves banks from facing liquidity issues.
Let us now look at how the Reserve Bank of India uses the concept of Repo Rate to control inflation within the economy and why will the Repo Rate hike cause the economic growth to slow down.
Whenever inflation within the economy increases and the prices of things go beyond a certain level, the RBI increases the Repo Rate. This leads to commercial banks having less money to lend. Therefore, they increase the rate of interest on loans, which in turn, deters new applicants from availing of loans and old loan payers left with little money to spend on inessential things due to higher EMIs. Thus, when RBI increases the Repo Rate, the flow of money within the economy decreases, which in turn, brings inflation under control. Unfortunately, this has a negative impact on country's economic growth. However, this is essential and must be done. This is the reason why the Reserve Bank of India has cut GDP forecast after the recent Repo Rate hikes.
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