In the context of Reserve Bank of India monetary policy, what are the repo rate and the reverse repo rate and how do they differ?

Introduction / Context:
Repo rate and reverse repo rate are two of the most important policy rates used by the Reserve Bank of India to manage liquidity and influence interest rates in the economy. This question checks whether you understand both definitions and the relationship between them. It is a common topic in banking, finance, and general awareness exams because changes in these rates affect borrowing costs, deposit rates, and overall economic activity.

Given Data / Assumptions:

• The context is RBI monetary policy and operations in the money market.
• We are concerned with short term transactions between RBI and commercial banks.
• The question asks for both the meaning of repo and reverse repo and how they differ.
• Government securities are used as collateral in these transactions.

Concept / Approach:
Repo stands for repurchase agreement. In a repo transaction, a commercial bank sells government securities to RBI with an agreement to repurchase them later at a predetermined price. The repo rate is the interest rate implied in this transaction and is effectively the rate at which RBI lends short term funds to banks. Reverse repo is the opposite. In a reverse repo transaction, RBI sells or takes securities from banks and borrows their surplus funds for a short period. The reverse repo rate is the interest rate that RBI pays to banks on these borrowed funds. Both operations use government securities as collateral but in opposite directions of cash flow.

Step-by-Step Solution:
Step 1: Define repo rate. It is the rate at which RBI provides short term liquidity to commercial banks by lending funds against the collateral of government securities.Step 2: Define reverse repo rate. It is the rate at which RBI absorbs liquidity from the banking system by borrowing funds from banks, again using government securities as collateral or underlying instruments.Step 3: Recognise that repo operations inject liquidity into the system while reverse repo operations withdraw or absorb liquidity.Step 4: Compare these definitions with the options. Option A correctly states that repo rate is the rate at which RBI lends to banks and reverse repo rate is the rate at which RBI borrows from banks.Step 5: Confirm that options B, C, and D talk about deposit rates, loan rates, or taxes, which are unrelated to these specific RBI policy rates.

Verification / Alternative check:
News about RBI monetary policy decisions always mention changes in repo rate and reverse repo rate. When RBI wants to encourage banks to borrow more and lend more, it may reduce the repo rate. When RBI wants to encourage banks to park more surplus funds with it, it may adjust the reverse repo rate. In all such reports, repo is clearly described as the rate at which RBI lends to banks, and reverse repo as the rate at which RBI borrows from banks. This confirms that the description in option A is accurate.

Why Other Options Are Wrong:
Option B links repo and reverse repo to savings and current account deposit rates, which are determined by individual banks and are not the same as RBI policy rates. Option C treats these rates as bank lending rates on home and personal loans, which are influenced by repo but are not defined as repo or reverse repo themselves. Option D talks about corporate tax and service tax, which belong to fiscal policy, not monetary policy. Therefore, these options do not capture the correct definitions.

Common Pitfalls:
A common confusion is to mix up the direction of cash flows and say that repo rate is the rate at which banks lend to RBI, which is incorrect. Another pitfall is to assume that repo rate directly equals loan interest rates to customers, without understanding that it is a benchmark that influences but does not equal retail rates. To answer such questions correctly, always remember that repo means RBI lends to banks, reverse repo means RBI borrows from banks, and both use government securities as collateral.

Final Answer:
Repo rate is the rate at which RBI lends short term funds to commercial banks against government securities, while reverse repo rate is the rate at which RBI borrows surplus funds from commercial banks against government securities.