How the Repo Rate Affects Inflation

How the Repo Rate Affects Inflation

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The interest rate that commercial banks must pay on borrowing from the RBI rises in response to an increase in the repo rate. The cost of the loans rises. This reduces the capacity of banks to make loans. This does it in two ways for the clients: To improve the amount of cash available to the bank, commercial banks increase the interest rates on deposit accounts for consumers. Consumers prefer to retain their money in banks because they receive higher returns on their savings. The amount of money in circulation or liquidity is decreased. As a result, demand falls. When the supply is constant, prices decline.

Second, banks raise the interest rates on loans such as mortgages and auto loans, among others. Consumers pay more for loans as a result. So, they choose to take out fewer loans, which lowers the amount of money they have available. Without loans, individuals are unable to make significant purchases like those for a new home, car, or in some situations, even school.

Less demand in the economy as a result of falling liquidity lowers inflation rates. On the other side, a decrease in the repo rate lowers the cost of loans and lowers deposit returns. Customers therefore prefer to keep their money on hand rather than using the banking system. This raises the amount of money available and boosts economic demand. Products' costs soar when there is an endless supply. When an economy is slowing down, it frequently happens.

Commercial banks must pay more to borrow money from the central bank once the RBI raises the repo rate. The higher interest rate is then passed on to the customer by the banks. This indicates that interest rates will rise on both bank loans and deposits. Customers pay more for both new and existing loans even when they receive a higher return on their funds when they park them in deposits. As a result, the amount of money that is liquid in the economy decreases. As a result, there is a decrease in the demand for consumer goods like homes and cars. In turn, this aids in containing retail inflation. The RBI begins lowering repo rates when inflation starts to decline in an effort to boost the amount of money in circulation. In most cases, there is a delay between sending rates to the end user. Banks begin to change their interest rates in response to RBI policy choices, which is why this occurs. Rates often trickle down to the borrower over the course of two to three months.