UPSC Mains Answer Writing

Question- Repo rate is also known as the Benchmark Interest Rate. What is the importance of the Repo Rate? How Repo Rate can be used to combat inflation?

Model Answer

Repo rate. also known as the benchmark interest rate, is the rate at which the RBI lends money to the commercial banks for a short term. Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI. RR is known as Benchmark Interest Rate because it is used to determine various rates used in monetary policy. Thus, change in Repo Rate will affect every other rate in the economy.

Importance of Repo Rate-

1. Repo Rate is the monetary measure used by the RBI to deal with the deficiency of funds and liquidity in the market. It is one of the vital money control mechanisms used by the RBI.

2. Bank lending and investment rates are decided based on the repo rate.

3. Repo Rate is the most effective and efficient tool used by the RBI to achieve price stability and to boost economic development.

4. Repo rate is among the most crucial monetary policy instruments available to the RBI.

5. There is a considerable rise in borrowing by commercial banks through the repo route which makes it an important element of India’s monetary policy framework. The constant nature of the balance between Repo and Reverse-Repo makes it more powerful in the Indian banking system.

RBI has the mandate to adopt a retail inflation target of 4 percent, plus/minus 2 percentage points on either side, till 31 March 2021.

In the event of inflation, central banks increase the repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation. The central bank takes the contrary position in the event of a fall in inflationary pressures. If inflation falls below 2%, the RBI decreases the Repo Rate, which motivates banks to borrow from RBI and ultimately reduces the money supply. The decreased money supply culminates into increased inflation.

RateIncreaseEffect on InflationDecreaseEffect on Inflation
Repo RateDecreased money supply in the economyDecreaseIncreased money supply in the economyIncrease
Reverse Repo RateIncreased money supply in the economyIncreaseDecreased money supply in the economyDecrease

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