Impact of interest (Repo) rate change on the economy

"𝗔𝗻𝗸𝘂𝗿, 𝗰𝗮𝗻 𝘆𝗼𝘂 𝗲𝘅𝗽𝗹𝗮𝗶𝗻 𝘁𝗵𝗲 𝗥𝗕𝗜 𝗿𝗮𝘁𝗲 𝗰𝗵𝗮𝗻𝗴𝗲 𝗮𝗻𝗱 𝗶𝗺𝗽𝗮𝗰𝘁 𝗼𝗻 𝘁𝗵𝗲 𝗰𝗼𝘂𝗻𝘁𝗿𝘆 𝘁𝗼 𝗮 𝟭𝟱-𝘆𝗲𝗮𝗿 𝗼𝗹𝗱?"

"Sure, I can try!"

So on 6th May 2022, there were some policy revisions by RBI. Let's talk about Repo (Interest) Rate and CRR. As with all things finance, these have a lot of jargon, but I'll try and simplify them.

Let's look at Repo Rate first (also known as interest rate)

𝗥𝗕𝗜 𝗶𝗻𝗰𝗿𝗲𝗮𝘀𝗲𝗱 𝗥𝗲𝗽𝗼 𝗥𝗮𝘁𝗲 𝗯𝘆 𝟰𝟬 𝗯𝗮𝘀𝗶𝘀 𝗽𝗼𝗶𝗻𝘁𝘀, 𝘁𝗼 𝟰.𝟰𝟬%

[Basis point is just a unit of measurement. 100 basis points = 1%. So 40 basis points = 0.4%]

Now Repo rate is the interest that the RBI charges to banks for lending money. Yes, banks borrow money from RBI too, and they pay interest on it, known as the Repo Rate.

Increasing this Repo rate means that banks will have to pay higher interest on the money that they borrow from RBI. And since the cost of borrowing is higher, this naturally means that they will also increase the interest that they charge to their customers for loans. So loans will get expensive.

Let's get to why this was done, in 30 seconds.

But before that let's look at the second part.

𝗖𝗥𝗥 𝘄𝗮𝘀 𝗶𝗻𝗰𝗿𝗲𝗮𝘀𝗲𝗱 𝗯𝘆 𝟱𝟬 𝗯𝗮𝘀𝗶𝘀 𝗽𝗼𝗶𝗻𝘁𝘀, 𝘁𝗼 𝟰.𝟱𝟬%

Now CRR stands for Cash Reserve Ratio. It is basically a percentage of total deposits that banks need to compulsorily keep with RBI.

So for example, if a bank has a total of 1000 crore worth of deposits, it will have to keep 45 crores with RBI.

Increasing this means banks have to keep more money with RBI, which means they have less money to lend or invest. So what banks do is, try to encourage people to make more deposits so that the bank gets more money available to lend. Customers therefore keep more money in the bank. Also, loans tend to get more expensive because the bank has lesser money.

𝗡𝗼𝘄, 𝘄𝗵𝘆 𝘄𝗮𝘀 𝘁𝗵𝗲 𝗥𝗲𝗽𝗼 𝗥𝗮𝘁𝗲 𝗮𝗻𝗱 𝗖𝗥𝗥 𝗶𝗻𝗰𝗿𝗲𝗮𝘀𝗲𝗱?

Let's see. Inflation in India is close to 7%, which is very high.

[Inflation is nothing but a rise in prices of goods and services. 1kg of wheat that cost Rs. 30 till 5 years ago, now costs Rs. 40. That's inflation]

Increasing Repo rate and CRR means that loans will get more expensive. That means that lesser people will borrow, which means lesser people will spend money on automobiles, homes and other goods and services. This means there is lesser money rolling in the economy, i.e there is lower 𝗹𝗶𝗾𝘂𝗶𝗱𝗶𝘁𝘆.

Due to this low liquidity, sellers will reduce prices of goods and services, since there are lesser people wanting to buy them.

Thereby controlling inflation.

And that's exactly why, RBI increased the Repo rate and CRR yesterday. It will be interesting to see the combined effect of increasing both in the coming few days!

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