During periods of excess liquidity in the banking system, what role does the reverse repo rate play in the RBI's monetary policy operations, and what impact does it have on commercial banks?
Show answer & explanation
Correct answer: B
Explanation
Solution: The correct answer is It allows the RBI to absorb surplus liquidity by offering an interest rate on funds parked by banks, thus discouraging excessive lending.
Explanation:
☛ Reverse Repo Rate is the interest rate at which the Reserve Bank of India (RBI) absorbs surplus liquidity from commercial banks by borrowing funds from them against eligible government securities.
☛ During periods of excess liquidity in the banking system, banks have surplus cash that can lead to excessive credit creation and fuel inflation.
☛ By offering an attractive reverse repo rate, the RBI provides an incentive for commercial banks to park their excess reserves safely with the central bank.
☛ Consequently, the lendable resources available with commercial banks decrease, which restricts unchecked credit growth and helps maintain price stability in the economy.
Extra Exam-Relevant Facts:
☛ Repo Rate: The rate at which commercial banks borrow short-term funds from the RBI by pledging government securities to address temporary liquidity deficits.
☛ Liquidity Adjustment Facility (LAF): Introduced in 2000 on the recommendations of the Narasimham Committee, allowing the RBI to manage liquidity through repo and reverse repo operations.
☛ Standing Deposit Facility (SDF): Operationalised in April 2022 by the RBI as an uncollateralised liquidity absorption tool, replacing the fixed-rate reverse repo as the floor of the LAF corridor.
☛ Cash Reserve Ratio (CRR): The mandatory fraction of total Net Demand and Time Liabilities (NDTL) that commercial banks must maintain as cash reserves with the RBI.
☛ Statutory Liquidity Ratio (SLR): The mandatory percentage of deposits that banks must preserve in liquid assets such as cash, gold, or approved government securities before providing credit.
Important One-Liners for Upcoming Exams:
☛ Which committee recommended the introduction of the Liquidity Adjustment Facility (LAF)? → Narasimham Committee (1998)
☛ What facility was introduced in 2022 by the RBI to absorb surplus liquidity without collateral? → Standing Deposit Facility (SDF)
☛ What is the primary difference between Repo and Reverse Repo operations? → Repo injects liquidity into the banking system, whereas Reverse Repo absorbs liquidity from it
☛ Under which statutory Act was the Reserve Bank of India established? → Reserve Bank of India Act, 1934
☛ How does an increase in the Reverse Repo Rate impact money supply in the market? → It decreases money supply by incentivising banks to park surplus funds with the RBI