Reverse Repo Rate is the rate of interest at which the Central Bank borrows funds from other commercial banks for a short duration. The commercial banks deposit their short term excess funds with the Central Bank and earn interest on it.
Reverse Repo Rate is used by the Central Bank to absorb liquidity from the economy. When it feels that there is too much money floating in the market, it increases the reverse repo rate, meaning that the Central Bank will pay a higher rate of interest to the banks for depositing money with it.
An increase in the Reverse Repo Rate causes the banks to transfer more funds to the Central Bank, because banks earn attractive interest rates and also their money is in safe hands. This results in the money withdrawn out of the banking system, thus banks are left with lesser funds.
Thus, by lowering repo rate, Central Bank injects liquidity in the banking system and by increasing reverse repo rate, it absorbs the liquidity from the banking system.
