I am a continuous reader of accountant education. This site is really helpful. Sir, I have a doubt how does increase in reverse repo rate forces banks to increase its interest rates. Increase in reverse repo rates helps bank to earn more then why banks increase in interest rates of commercial loans at the same time.
Waiting to hear from you,
Libin Jacob. from India
Libin Jacob! You have asked good question. You know that reverse repo rate is that rate at which RBI gets loan. If RBI increases this reverse repo rate, it means RBI wants to contraction of credit. How is it possible with reverse repo rate. When RBI gets loan from banks at high rate of interest, more and more banks will supply to central bank because it is safe and earning is more. Effect of this will on financial market. Supply of money in financial market will decrease. In economics, it is simple rule, if supply is limited and demand increases, price of product will increase. Bank has lots of demand but due to limitation of supply, bank increases interest rate. That is the reason. But its positive effect will on credit. Due to decrease in the supply of credit in the market, inflation rate will decrease.
Now, I explain, how will price of product will decrease. People can buy the product even the prices increase, if they have money. Loan is also source of money. People get loan and buy their products. With increasing reverse repo rate, loan is transfer to central bank. Now, people will have to pay more interest on limited loan. They will not get loan at high interest. Due to this, they will not buy the goods when prices increases. When businessmen's products will not sell, they have to decrease prices. When prices will decrease inflation will under control.