Context
In a recent report, State Bank of India, which is the largest public sector bank in the country, has stated that the stage is set for a reverse repo normalisation.
What is monetary policy normalisation?
- India’s central bank, the RBI, keeps changing the total amount of money in the economy to ensure smooth functioning by following two approaches.
- Loose monetary policy
- Tight monetary policy
- Loose monetary policy
- It is adopted when the RBI wants to boost the economic activity.
- RBI injects more money (liquidity) into the economy: It does so by buying government bonds from the market. As the RBI buys these bonds, it pays back money to the bondholders, thus injecting more money into the economy.
- RBI also lowers the interest rate: that it charges banks when it lends money to them; this rate is called the repo rate. Lower interest rates and more liquidity, together, are expected to boost both consumption and production in the economy.
- Significance
- Boosts consumption- For a consumer, it would now pay less to keep the money in the bank thus incentivising current consumption.
- Boosts production- For firms and entrepreneurs, it would make more sense to borrow money because interest rates are lower.
- Tight monetary policy-
- It involves the RBI raising interest rates and sucking liquidity out of the economy by selling bonds (and taking money out of the system).
- When a central bank finds that a loose monetary policy has started becoming counterproductive (leading to a higher inflation rate), it normalises the policy by tightening the monetary policy stance.
What is Reverse Repo?
- The reverse repo is the interest rate that the RBI pays to the commercial banks when they park their excess “liquidity” (money) with the RBI.
- The reverse repo, thus, is the exact opposite of the repo rate.
- Under normal circumstances, that is when the economy is growing at a healthy pace, the repo rate becomes the benchmark interest rate in the economy.
- That’s because it is the lowest rate of interest at which funds can be borrowed.
- As such, the repo rate forms the floor interest rate for all other interest rates in the economy — be it the rate you pay for a car loan or a home loan or the interest you earn on your fixed deposit etc.
