Repo Rates - Unfolded

What is it ?

The repurchase or repo rate is the interest rate at which the Reserve Bank lends money to private banks. The Reserve Bank acts as banker for private banks. Banks experience a cash shortfall or a need for liquidity on a daily basis and their lender of last resort is the Reserve Bank. A formal system is in place to guide the process through which banks borrow from the Reserve Bank and it is called the repurchase transactions system (repo system for short). The repo system of borrowing and lending involves the temporary sale of a financial asset by the borrower (bank) in exchange for the needed cash from the lender (Reserve Bank). In such a transaction, there is an explicit agreement that the borrower must repurchase the financial assets at an agreed future date – currently after one week. The repo rate is determined by the Reserve Bank at each meeting of its Monetary Policy Committee. It is expressed as a rate per annum. The repo rate serves as a benchmark for the level of short-term interest rates. 

How Does it deal with Inflation ? 

If the repo rate increases, banks have to pay more for repo funds. To maintain their existing profit margins, banks raise the interest rates at which they take deposits from and lend money to their customers. This causes a general rise in interest rates or the cost of holding money, and this eventually helps to control inflation by reducing the demand for credit to be spent on the purchase of goods and services. The actions of the Bank described here are also known as the formulation and implementation of monetary policy.