Tools used by RBI to tame the inflation.

Below are some of the tools that can be used by the RBI (Reserve Bank of India) to tame the inflation.

Repurchase (Repo) rate is the rate at which RBI lends money on a short term basis to the banks operating in India. When the Repo rate is increased, borrowing money from RBI becomes expensive. Hence one can say that, in case RBI wants to make it more expensive for the banks to borrow money, it increases the Repo rate; on the other hand to make it cheaper for banks to borrow money, it would go ahead and reduce the Repo rate.

Reverse Repo rate is the rate at which banks park their excess money with the RBI on a short term basis. RBI uses this tool when it feels there is too much money floating within the banking system. An increase in the reverse repo rate means that the RBI will borrow money from the banks at a higher rate of interest. As a result of this, the banks would prefer to keep their money with the RBI rather than lending it out to loan seekers.

Basically, one can consider both repo and reverse repo as interbank interest rates through banks lend  to or borrow money from the central bank (in our case it's RBI). Increasing repo or reverse repo rates is a way through which RBI tries to suck out the excess money from the financial system of the country and thus reduce inflation or increase in price due to extra purchasing power in people's hand. This creates a liquidity crunch which means less money is available for investment, growth and expansion of the industry and thus slows down the development and growth. So if you look at it in the short term, this has a negative effect on the market. Because of this reason, RBI can use this weapon sparingly and only in small doses. However, if the inflation is too high this measure is beneficial for the overall market due to the very fact that the inflation tends to come down, and companies will pay less for the raw materials which in turn would increase their profits. And as this process of cost reduction cascades down, individuals would end up cash in hand  though marginally. But in reality this gets much more complex than this. The banks in response to a change in these two rates would increase or decrease their own interest rates (depending on the action taken by RBI).

CRR which means Cash Reserve Ratio. Banks in India need to maintain a certain proportion of their deposits in the form of cash. However, they (banks) don't hold this cash with themselves, they would in turn deposit with RBI or currency chests which is considered as holding cash with themselves. This minimum ratio is dictated by the RBI is known as cash reserve ratio. Assuming that current CRR is 9%, the banks will have to deposit Rs 9 with RBI for every deposit increase of Rs 100, thus the bank would be left over with only Rs 91 for their investment or lending purpose. Hence higher the CRR, lower is the amount that the banks are eligible to invest their money. This power of RBI to reduce the over all lending money within the banks by increasing the CRR makes it an instrument through which RBI can control the overall money within in the banking system that can be lend. CRR which is much more powerful than repo and reverse repo. The effect of CRR is much higher and deeper to our markets than that of the other two and this is the reason why RBI uses it even more sparingly.