Reverse Repo Rate

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21 Aug, 2024

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Reverse Repo Rate Meaning

The reverse repo rate refers to the interest rate paid by a nation's central bank when it borrows funds from commercial banks. The funds are borrowed for a short duration. Governments use it as a monetary measure to check inflation and money supply.

An increase in the reverse repo rate is considered a contractionary monetary policy. It curtails the money supply (liquidity) and reduces inflation. A decrease in the reverse repo rate is considered an expansionary monetary policy step. It induces liquidity, i.e., increases the money supply in the market.

Reverse Rate Meaning

The reverse repo rate is the percentage of interest paid by a nation's central bank for borrowing funds from commercial banks. Funds are lent for a short period.
The Federal Reserve uses the reverse repo rate as a monetary policy to correct inflation, recession, or depression.
Lower rates boost loans and increase the money supply. Money supply signifies purchasing power and results in higher demand. Therefore, central banks use it to tackle recessions.
For commercial banks, excess funds are not profitable, so they voluntarily park extra funds with the central bank when the rate is increased.

Reverse Repo Rate Explained

The reverse repo rate is applicable when the central bank borrows money from commercial banks to control the money supply in the markets. It is always less than the repo rate charged by the central bank—when it lends funds to commercial banks. The repo rate is an income for the central bank; to generate profits, it needs to be higher than the expenses.

The central bank modifies the reverse repo rate to correct the economy—monetary policy mechanism. By implementing various expansionary and contractionary monetary measures, the Federal Reserve plays a key role in controlling economic phases—inflation, recession, and depression. The reduction or increase in reverse repo rate is one of those measures.

Video Explanation of Bank Rate vs Repo Rate

Reverse Repo Rate Function

At the time of inflation, the central bank imposes contractionary measures. It increases the repo rate—commercial banks find it unappealing to borrow funds from the central bank.

Consequentially, commercial banks don't have sufficient funds to lend further—to their customers. The contraction of the money supply is achieved. When the public has little money to spend, demand for goods and services also drops. Gradually, as demand falls, the level of inflation also decreases.

Similarly, during the recession, the central bank implements expansionary monetary policies. The central bank decreases repo rates—this encourages commercial banks to borrow more from the central bank. When commercial banks have sufficient funds, they lend them to their customers—who spend them on goods and services. It is a chain reaction that results in an increased money supply. Ultimately, there is an improvement in the overall economy.

Example

On June 17, 2021, the Federal Reserve implemented monetary policy measures to control price inflation in the US. The Fed Reserve provided an overnight reverse repurchase agreement facility by augmenting five basic points off the reverse repo rate—soaring from 0.00% to 0.05%. Banks and money market funds parked a huge sum of $755.80 billion with the Fed Reserve—within a day.

The rate appraisal provided support to banks and money market investors who were otherwise unwilling to block their funds in an unstable market. Interest rates were falling globally.

Impact on Economy

The reverse repo rate is a crucial monetary policy measure. There are following two types of measures adopted by the central bank:

Increasing the reverse repo rate: It is a contractionary monetary policy that aims to reduce inflation in the economy. When the central bank offers a higher reverse rate on funds, commercial banks find it profitable and provide surplus funds—for a short period.

In doing so, commercial banks are left with little funds—cannot extend loans to the public. The impact is more visible with home loans. Naturally, this reduces people’s purchasing power—demand for goods and services falls. Ultimately, there is a gradual decline in inflation and market liquidity.

Decreasing the reverse repo rate: When there is an economic slowdown (recession or depression), the central bank resorts to expansionary monetary policies. Curtailing the reverse repo rate is one option—It discourages commercial banks from parking their excess funds with the central bank.

Thus, commercial banks extend more loans to the public—from this surplus fund. When customers find sufficient money at their disposal, their purchasing power increases. Consequentially, the demand for goods and services in the market increases. The rise in demand ultimately accelerates the economy, improves liquidity, and controls recession.

Frequently Asked Questions (FAQs)

What is the reverse repo rate?

The reverse repo rate is a percentage of interest earned by commercial banks. They get an interest on the surplus fund parked with the central bank. The central bank borrows funds for the short term. It is a part of the monetary policy imposed by central banks to regulate the supply of money in the economy—either to combat inflation or recession.

What happens when the reverse repo rate increases?

An increase in this rate is considered a contractionary monetary policy—it reduces the supply of money in the economy. When commercial banks are offered better interest rates for a short duration, they curtail public lending. Consequently, the money supply plummets.

Why is the reverse repo rate important?

The central bank uses it as a key monetary policy to keep the economy liquid and keep inflation under control. The central bank obtains funds from banks when it is required. In exchange, the central bank rewards commercial banks with lucrative interest rates. For commercial banks also, excess funds are not profitable, so they voluntarily park extra funds with the central bank to receive a greater interest rate.

Why is the reverse repo rate lower than the repo rate?

The repo rate is the interest paid by commercial banks when they borrow funds from the central bank. Thus, it is an income for the central bank. The reverse repo rate, on the other hand, is paid by the central bank when it borrows from commercial banks—for a short duration. Clearly, it is an expense for the central bank. Therefore, the central bank has to make sure that the it is lower than the repo rate.