What is Reverse Repo Rate?
Reverse Repo rate (also known as Reverse Repurchase rate) is the rate at which the Central Bank of the country (in India, RBI is the central bank) borrows shot-term money from the banks. In other words, we can say that the Reverse Repo rate is a rate at which banks lend money to RBI for a short period to manage their excess liquidity. Therefore, it can be said the reverse repo rate is an instrument of monetary policy which RBI uses to absorb liquidity from the bank.
How does change in Reverse Repo Rate affect liquidity system?
The banks use this tool to park excess liquidity with RBI when they are unable to get reasonable returns. Whenever, RBI wants to drain excess money out from the banking system, it increases the reverse repo rate. Because by increasing the reverse repo rate, RBI is ready to borrow money from the banks at a higher interest, consequently banks would prefer to lend surplus fund to RBI.