Reverse Repo Rate refers to the rate of interest paid by the Central Bank on deposits made by the Central Bank on deposits made by the Commercial Banks. When it is raised, commercial Banks are encourage to make more deposits with Central Bank. As a result, funds available for lending with the Commercial Banks decrease. Their capacity of lending declines and Credit Creation is less.
Detailed Answer:
The rate at which Central Bank borrows money from the banks is termed as Reverse Repo Rate. The Central Bank uses this tool when it feels there is too much money floating in the banking system. In case of a rise in the Reverse Repo Rate, it becomes more profitable for the Commercial Banks to lend to Central Bank, since they will now get higher amount against the amount lent. This implies higher the amount lent, higher are the returns. Thus, the Commercial Banks aim to transfer greater amount of funds to the Central Bank. This, in turn implies that the Commercial Banks are left with less surplus funds that they can lend to the general public. Hence, the lending capacity of the Commercial Banks reduces. This would further imply lesser amount of credit and money flowing within the economy, hence, lesser money supply. This results in the reduction in the credit creation capacity of Commercial Banks. A rise in reverse repo rate is desirable by the Central Bank if it aims at contracting monetary policy. However, on the contrary if the Central Bank aims at expansionary monetary policy, then it at first instance reduces the Reverse Repo Rate, which in tum makes the lending unattractive and discourages the Commercial Banks to lend to the Central Bank. Thereby, a fall in the reverse repo rate restricts the flow of money and credit in an economy.
