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Question
Explain the role of Repo rate and Reverse Repo rate in correcting deflationary gap in an economy.
Solution
The repurchase rate is referred to as the repo rate. This is the interest rate at which commercial banks borrow money from the Central Bank in exchange for securities with the promise to buy them back after a set period of time. Similarly, the Reverse Repo Rate is the interest rate at which commercial banks lend to the Central bank. The reverse repo rate is always a few basis points lower than the repo rate.
When the repo rate falls, commercial banks, loans become less expensive, lowering interest rates on loans to the general public. The decrease in interest rates increases the demand for loans for both investment and consumption purposes.
As a result, aggregate demand has started to increase. Similarly, when the Reverse Repo rate is lower than the repo rate, banks prefer to park their funds with the Central Bank and use that fund to make loans to the general public, thus also expanding credit. This has a positive effect on aggregate demand by closing the deflationary gap.
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