The Reserve Bank of India has various tools to control and maintain liquidity in the market. Two among them are the CRR and Repo rate.
CRR: Cash Reserve Ratio (CRR) is the ratio of deposits banks must maintain with the Reserve Bank of India. This implies that if a person deposits Rs 1,000 in his account, the bank can use it to lend others, but it has to deposit a percentage of that amount with the RBI. Hence, if CRR is 5%, the lender will deposit Rs.50 with the RBI and has Rs.950 left at its disposal.
Repo Rate: The repo or repurchase rate is the interest charged by the RBI to banks when they approach it for short term loans.
The repo rate is linked to the interest rate borrowers pay when they take loans from banks because the latter always charges interest which is higher than the existing repo rate. Hence, lower repo rates could induce lenders into lowering the interest rates they charge from individual borrowers too, thereby making credit more affordable.
CRR determines bank interest rates: If a man had deposited Rs.1,000 in his account when the CRR was 5%, the bank will have at its disposal Rs.950 after it deposits Rs.50 as CRR. The bank in turn lends the Rs.950 to a borrower who will eventually repay the bank.
The bank will once again lend this amount (Rs.950) to another borrower after depositing 5% of the amount (Rs.47.5) to the RBI. In this manner, the money will keep exchanging hands, or it continues to be created and available for subsequent borrowers. This means that Rs.1,000 is helping generate a far higher amount in the economy in an indirect manner. Therefore, even if the CRR were to be increased by only 1%, the money generated in the economy would reduce drastically.
Repo rate and inflation: When the repo rate is raised, banks are compelled to pay higher interest to the RBI which in turn prompts them to raise the interest rates on loans they offer to customers. The customers then are dissuaded in taking credit from banks, leading to a shortage of money in the economy and less liquidity. So, while on the one hand, inflation is under controlled as there is less money to spend, growth suffers as companies avoid taking loans at high rates, leading to a shortfall in production and expansion.
The RBI revises CRR and repo rates in their quarterly and mid-quarter policy reviews to maintain a balance between growth and inflation. The past two years have been proof of this practice as the apex bank tried to first tame the monster of inflation with aggressive rate hikes, and once it saw growth taking a hit, reduced key rates to revive the economy.