Relation between Inflation and Bank interest Rates: How does inflation affect rates?

Relation between Inflation and Bank interest Rates: How does inflation affect rates?

Inflation, in simple terms is a sustained increase in general price level. In other words, it can also be described as a situation in which excess money chases fewer goods, causing increase in demand of goods and thus leading to an increase in price. Thus if this demand created by excess money can be curtailed, inflation would be contained. This is the genesis behind controlling inflation through monetary policy.

If inflation is high, interest rates are increased. If repo, ie rates at which banks borrow from RBI, is increased, such borrowing will become costly and banks would thus either borrow less or pass on this increased cost to their borrowers. Again if reverse repo is increased, banks would divert more funds towards RBI and excess liquidity will be absorbed by RBI rather than going at cheaper cost in the economy. In either of the cases, actual lending will be less and demand for goods and services will be less

In the case of CRR, if the rate is increased, it affects in two ways. First, immediate liquidity in the system is absorbed to the extent CRR is increased as more money needs to be placed with the regulator. Second, in the incremental lending, potential capacity of banks to lend is curtailed. This again leads to less lending by banks.

Another ratio which does not directly affect inflation but is important for banking is statutory liquidity ratio.