Liquidity Adjustment Facility

The Liquidity Adjustment Facility (LAF) is a tool used by the Reserve Bank of India (RBI) to regulate short-term liquidity in the banking system and manage interest rates. It consists of two key instruments:

1. Repo Rate (Repurchase Agreement) – Banks borrow money from the RBI by pledging government securities and agreeing to repurchase them later. The repo rate is the interest rate at which this borrowing happens. An increase in the repo rate makes borrowing costlier, reducing liquidity, while a decrease makes borrowing cheaper, increasing liquidity.
2. Reverse Repo Rate – Banks park their excess funds with the RBI and earn interest at the reverse repo rate. When the RBI increases the reverse repo rate, banks are incentivized to deposit more money with the RBI, reducing liquidity in the market.

The LAF is crucial for controlling inflation, managing money supply, and stabilizing short-term interest rates in the Indian economy. The RBI conducts LAF operations daily to ensure smooth liquidity conditions.