Chapter 25: Problem 5

Write a short note on the bank rate policy.

Short Answer

Expert verified

Short Answer: The bank rate policy refers to the central bank's control of the rate at which it lends money to commercial banks. This tool helps to regulate the money supply in the economy by influencing borrowing, lending, and interest rates. The primary objectives of the bank rate policy include maintaining price stability, controlling inflation, stimulating economic growth, and impacting exchange rates. While the policy can be effective in achieving these goals, its success depends on the responsiveness of banks to rate changes and external economic factors. Furthermore, the policy may have limitations in times of financial turmoil or lead to unintended consequences such as encouraging speculative activities or causing volatility in financial markets.

Step by step solution

Introduction to the bank rate policy

The bank rate, also known as the discount rate or policy rate, is the rate at which a central bank lends money to commercial banks. This monetary policy tool is used to influence the borrowing and lending activities of banks, thereby controlling the money supply in the economy. By adjusting the bank rate, the central bank can influence the general level of interest rates and, consequently, the availability of credit in the economy.

Objectives of the bank rate policy

The key objectives of the bank rate policy are to maintain price stability, control inflation, stabilize economic growth, and influence the exchange rate. By manipulating the bank rate, the central bank can ensure that the economy has an adequate supply of money and credit to support economic activities. Additionally, the bank rate policy can help maintain investor confidence and encourage savings and investments, which are essential for sustained economic growth.

Effects of changing the bank rate

When the central bank increases the bank rate, it becomes more expensive for commercial banks to borrow money. As a result, banks may also increase their lending rates, making credit costlier for businesses and consumers. This may lead to a decrease in borrowing, spending, and ultimately, a contraction in the money supply. The reduced spending can help curb inflation and maintain price stability. On the other hand, when the bank rate is reduced, it becomes cheaper for banks to borrow, and they may pass this benefit on to their customers by lowering lending rates. This stimulates borrowing, spending, and investment in the economy, thus leading to economic growth.

Critique of the bank rate policy

While the bank rate policy is an essential tool in the central bank's arsenal, it is not without its limitations. Changes in the bank rate may take time to affect the broader economy, as it depends on the transmission mechanism of these changes through the banking sector. Moreover, bank rate policy may not be as effective in times of financial turmoil, when risk aversion among banks can lead to limited changes in actual lending rates. Additionally, changes in bank rates can sometimes have unintended consequences, such as encouraging speculative activities or causing volatility in the financial markets.

Conclusion

To sum up, the bank rate policy is an important monetary policy instrument that central banks use to control the money supply and interest rates in the economy. By adjusting the bank rate, central banks can influence borrowing and lending activities, steer economic growth, and maintain price stability. However, the effectiveness of the bank rate policy depends on various factors, including the responsiveness of commercial banks to changes in the bank rate and the overall economic environment.