Methods of credit control and combating inflation written by MS Navya Fourth Article
BANK RATE POLICY
It is also known as discount rate policy. Bank rate is the rate at which the Central Bank is prepared to rediscount the approved bills or to lend on eligible paper.
This weapon can be used independently or along with other weapon. By changing this rate the Central Bank control the volume of credit. The bank rate is raised in times of inflation and is lowered in times of deflation.
A rise in the bank rate is usually preceded by the following events:
(i) Over supply of money and rising price level.
(ii) Great demand for money caused by active trade.
(iii) Adverse rate of exchange, and
(iv) Un favourable balance of trade.
In times of adverse balance of payments and rising price level, the Central Bank increases the bank rate and thereby forces the market rates to go up. Because of this, credit becomes dear and borrowing from banks becomes costly. The speculators are discouraged to buy and stock goods.
They start selling their stock of goods in the market, and the prices take a downward trend. Exports begin to rise and the imports decline. Foreign investors are encouraged to keep their cash balances within the county so as to earn the increased rate of interest. The adverse balance of payments gradually disappears.
A rise in bank rate has the following consequences
1.There is a corresponding rise in the market rate that is, the rate charged by financial institution.
2.The prices of fixed interest bearing securities tend to register a decline because the interest rate ruling in the market would be higher than the rate originally fixed on such securities.
3. A shift in investments from fixed interest bearing securities to equities results in a rise in the prices of the latter, especially, shares of growing companies.
4.There is shrinkage in investment on capital assets due to the shortage of finances.
5.Fall in the prices of consumer commodities due to less spending and the unloading of stocks.
6.Transference of foreign money into the country due to the high rates of interest ruling and the consequent improvement in the foreign exchange position.
7.Increase in exports.
8.But in times of falling prices, the Central Bank lowers the bank rate and brings about a fall in the market rates of interest. This will lead to increased volume of trade, investment, production and employment and ultimately leads to the rise in the price level.
Conditions for the Operation of Bank Rate Policy
To use the weapon of bank rate policy some basic requirements are to be fulfilled. The impact of a change in the Bank rate depends upon the following:
(i) Existence of close nexus between Bank Rate and market rates, i.e., the extent of the dependence of commercial banks on the Central Bank for funds.
(ii) The availability of funds to banks from other sources.
(iii) The extent to which other interest rates are directly influenced by changes in the bank rate. If the other rates of interest in the market do not respond to bank rate changes desired results cannot be realized.
(iv) The degree of importance attached to a change in the bank rate as an indicator of the monetary policy.
(v) There must be an organized short-term funds market in the country
(vi) There must be a great measure of elasticity in the economic structure of the country. When prices fall, the various elements in the cost of production like wages citations of Bank Rate Policy
The report of Macmillan Committee stated that the bank rate policy is an absolute essay for the sound management of a monetary system. It is an important weapon of edit control.”But, it suffers from the following limitations:
(i) The rate of interest in money market may not change according to the changes in the bank rate.
(ii) In rigid economic system, i.e., planned and regulated economies, the prices and costs may not change as a result of changes in the rate of interest.
(iii) The bank rate cannot be the sole regulator of the economic system, and the volume of savings and investments cannot be controlled through the rate of interest alone. The effectiveness of changes in interest rate depends upon the elasticity of demand for capital goods.
(iv) The effect of rise in the bank rate in controlling credit for industrial and commercial purpose is limited. If the businessmen take the view that prices will continue to rise, a slight rise in the rate of interest will not discourage them to expand their activity with borrowed money. So long as prices have a tendency to rise and so long as there is business optimism, businessmen would be willing to pay higher interest rates.
(v) In ties of depression, a fall in the rate of interest can hardly stimulate economic activity. Because the businessmen may not be prepared to increase their activity if they fear about the future. Prof. Sayers considers the bank rate as a halting, clumsy and indeed a brutal instrument.
(vi) The change in the methods of financing by the business firms reduces the importance of bank rate policy In recent years the commercial banks have ample liquid resources of their own. The business firms depend more on sloughing back of profits than borrowing from commercial banks.
(vii) The conflicting effects of bank rate also reduce the importance of this weapon. When the bank rate is increased the foreign capital may flow into the country, thus, making credit control difficult.
(viii) Indiscriminate nature of bank rate policy: The bank rate policy does not discriminate the activities into productive and unproductive activities. It affects both the activities on the same footing. This will adversely affect the genuine productive activities with increased rate of interest.
Because of these limitations, the bank rate policy has lost its importance. But during e inflationary situations it can be used with some modifications. But it may not regain its order importance.