The bank rate is the earliest method of credit control which was used by bank of England till the outbreak of the First World War.
Bank rate’ is also referred to as ‘discount rate’, “is the rate of interest which central bank charges on loans and advances that it extends to commercial banks and other financial intermediaries”
The central bank gives loans to commercial banks against eligible securities or by rediscounting bills of exchange.
Bank rate affects the cost and availability of credit. It is important because it is the pace setter to the other market rates of interest. The money market rate will automatically adjust to the bank rate. The central bank can change the bank rate to change the money supply in the economy.
A change the bank rate by the central bank –
a] Increase in the bank rate – will increase the cost of borrowing of commercial banks and therefore commercial banks will
i) Restrict borrowing ie they will increase their market rate to cover the increased cost of borrowing. This will discourage the business community from borrowing and therefore loans and advances of commercial banks will reduce leading to a fall in investments, fall in employment and fall in money supply. This will reduce aggregate demand in the country and check inflation.
ii) Check liquidity in circulation – due to increase in market rate, the rate of interest on deposits will increase. Existing customers will increase their deposits and new customers will be attracted to deposit more money. The liquidity in circulation will therefore reduce.
This policy is known as the dear money policy, tight money policy, credit squeeze policy or contraction of credit.
b] Decrease in bank rate – will decrease the cost of borrowing of commercial banks and therefore commercial banks will
Decrease in bank rate – will decrease the cost of borrowing of commercial banks and therefore commercial banks will
i) Promote borrowing ie they will decrease their market rate because of a fall in the cost of borrowing. This will encourage the business community to borrow and therefore loans and advances of commercial banks will increase leading to a rise in investments, rise in employment and rise in money supply. This will increase aggregate demand in the country and check deflation.
ii) Increase liquidity in circulation – due to decrease in market rate, the rate of interest on deposits will decrease. Existing customers will decrease their deposits and new customers will not be attracted to deposit money. The liquidity in circulation will therefore rise.
This policy is known as the cheap money policy, expansion of credit.
Essential conditions for the success of the bank rate policy.
a] There should be a close relation between bank rate and other market interest rates.
b] There should exist elasticity in the economic structure of the country.
c] The successful functioning of the bank rate policy requires existence of a well develop and well organize short term funds in the country.
Limitations of bank rate policy
a] In developing countries the money and capital markets are not well developed and integrated. Also there exists a non-monetised sector. A change in bank rate therefore may not influence the market rates of interest.
If for example, the bill market is underdeveloped, or if there is no market for money on call and short notice, the market will fail to respond to the bank rate changes.
b] Bank rate and market rate moving in the same direction creates its own problem. eg when central bank increases bank rate to control volume of credit in the country and market rate increases, there will be an inflow of foreign capital adding to foreign exchange assets of the central bank. This will increase the domestic money supply and defeat the very objective of increasing the bank rate.
c] The assumption that an increase in the bank rate will increase the interest paid on deposits will increase in bank deposits may not be true. Eg when people save due to precautionary motive the rate of interest will not influence savings. It is actually their income that influences their deposits.
d] Another limitation is the existence of conflict between the internal and external effects of the bank rate policy.
e] The commercial banks acquire sufficient liquid resources [enough excess reserves] of their own with the result that they have no need to approach the central bank for financial accommodation.
f] Governments in various countries have imposed all sorts of restrictions on foreign exchange and on international movement of capital, which has reduced the influence of the bank rate policy in recent years.
g] The greatest weakness of bank rate policy as a method of credit control is its impersonal nature.
h] The method of bank rate policy appears to be more effective only when marginal adjustments are to be made in cash reserves of the commercial banks and is found ineffective when large changes are intended.
i] The bank rate policy does not produce immediate effects on the cash reserves of the commercial banks. This time lag reduces the success of the policy
j] The psychological reactions to a change in the bank rate should also be considered for the effectiveness of the bank rate policy.
If in a boom period, businessmen are unduly optimistic, their demand for credit will be interest-inelastic and the bank rate will be ineffective.
Similarly, during depression, the pessimism of businessmen will not consider low interest rate as incentive.
It is true that businessmen are influenced by rates of interest, but they are more influenced by business expectations.
k] It cannot be flexible as the method of open market operation.
l] This method is only an indirect method which influences at first the cost and availability of credit and then the willingness of the customers to borrow and invest in business.
m]. The effectiveness of bank rate as a weapon of monetary policy has decreased over time. A variety of financial instruments has come into existence and business sector has learn to do with more of mutual credit and other means of doing business. As a result, the dependence of the domestic markets over the central bank has decreased.