ICSA Civil Services (Prelims) GS Indian Economics Exam 2012: Lecture 8 by Pro...
POLICY RATES IN INDIA
1. For latest rates check here.
bps
It is an acronym for basis point and is used to indicate changes in rate of interest and other
financial instruments. 1 basis point is equal to 0.01%. So when we say that repo rate has been
increased by 25 bps, it means that the rate has been increased by 0.25%.
Repo Rate and Bank Rate
People often get confused between these two terms. Though they appear similar there is a
basic difference between them.
Repo rate or repurchase rate is the rate at which banks borrow money from the central bank
(read RBI for India) for short period by selling their securities (financial assets) to the central
bank with an agreement to repurchase it at a future date at predetermined price. It is similar to
borrowing money from a money-lender by selling him something, and later buying it back at
a pre-fixed price.
Bank rate is the rate at which banks borrow money from the central bank without any sale of
securities. It is generally for a longer period of time. This is similar to borrowing money from
someone and paying interest on that amount.
Both these rates are determined by the central bank of the country based on the demand and
supply of money in the economy.
Reverse Repo Rate
Reverse repo rate is the rate of interest at which the central bank borrows funds from other
banks for a short duration. The banks deposit their short term excess funds with the central
bank and earn interest on it.
Reverse Repo Rate is used by the central bank to absorb liquidity from the economy. When it
feels that there is too much money floating in the market, it increases the reverse repo rate,
meaning that the central bank will pay a higher rate of interest to the banks for depositing
money with it.
CRR (Cash Reserve Ratio)
Banks are required to maintain a percentage of their deposits as cash, meaning that if you
deposit Rs. 100/- in your bank, then bank can’t use the entire Rs. 100/- for lending or
investment purpose. They have to maintain a portion of the deposit as cash and can use only
the remaining amount for lending/investment. This minimum percentage which is determined
by the central bank is known as Cash Reserve Ratio.
So if CRR is 6% then it means for every Rs. 100/- deposited in bank, it has to maintain a
minimum of Rs. 6/- as cash. However banks do not keep this cash with them, but are required
to deposit it with the central bank, so that it can help them with cash at the time of need.
2. SLR (Statutory Liquidity Ratio)
Apart from keeping a portion of deposits with the RBI as cash, banks are also required to
maintain a minimum percentage of deposits with them at the end of every business day, in the
form of gold, cash, government bonds or other approved securities. This minimum
percentage is called Statutory Liquidity Ratio.
Example
If you deposit Rs. 100/- in bank, CRR being 6% and SLR being 8%, then bank can use 100-
6-8= Rs. 86/- for giving loan or for investment purpose.
How it effects us
Having understood the meaning of these banking terms, let us now see how we are affected
by increase/decrease of these rates.
The central bank uses these rates to control inflation.
All About Inflation
Inflation and Types of Inflation
Banks earn profit by borrowing at a lower rate of interest from the central bank, and lending
the same amount at a higher rate to the customers. If the repo rate or the bank rate is
increased, bank has to pay more interest to the central bank. So in order to make profit, banks
in turn increase their interest rate at which they take deposit from the customer and lend
money to the customer. So the demand for loan decreases, and people start putting more and
more money in bank accounts to earn higher rate of interest. This helps in controlling
inflation.
An increase in Reverse repo rate causes the banks to transfer more funds to the central bank,
because banks earn attractive interest rates and also their money is in safe hands. This results
in the money being drawn out of the banking system, thus banks are left with lesser funds.
Thus, by lowering repo rate, central bank injects liquidity in the banking system and by
increasing reverse repo rate it absorbs liquidity from the banking system.
Increase in SLR and CRR rate means that banks will have less power to give loans (see our
example above), which again controls amount of money floating in the market; thereby
controlling inflation. It also makes banks safer to keep money because banks will have a
higher liquidity to meet the demand of customers. As we learnt from the recession, giving
loans expose banks to great risks. So if banks have lesser funds to give as loan, they become
relatively safer.
Conclusion
Thus we conclude that the central bank of a country uses these rates to fight inflation and to
keep a check on economy.
3. I’m sure you’ll also want to know the meaning of numbers written on debit and credit cards
and also the meaning of numbers written at the bottom of a cheque – two of the most read
articles on Knowledge Hub.
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