Bank Rate Policy or the Discount Rate Policy has been the earliest instrument of quantitative credit control. It was the Bank of England which experimented with the bank rate policy for the first time as a technique of monetary management. Now every central bank has been endowed with this instrument of credit control.
Bank rate refers to the official minimum lending rate of interest of the central bank. It is the rate at which the central bank advances loans to the commercial banks by rediscounting the approved first class bills of exchange of the banks. Hence, bank rate is also called as the discount rate.
Theory of Bank Rate
The theory underlying the operation of bank rate is that by manipulating the bank rate, the central bank is in a position to exercise influence upon the supply of credit in the economy.
According to the theory of bank rate an increase or a decrease in the bank rate leads to a reduction or an increase in the supply of credit in the economy. This is possible because changes in the bank rate bring about changes in the other rates of interest in the economy.
Working of Bank Rate
As mentioned above, by manipulating the bank rate it is possible to effect changes in the supply of credit in the economy. During a period of inflation, to arrest the rise in the price level, the central bank raises the bank rate. When the bank rate is raised, all other interest rates in the economy also go up.
As a result, the commercial bank also raise their lending rates. The consequence is an increase in the cost of credit. This discourages borrowing and hence investment activity is curbed in the economy. This will bring about a reduction in the supply of credit and money in the economy and therefore in the level of prices.
On the other hand, during a period of deflation, the central bank will lower the bank rate n order to encourage business activity in the economy. When the bank rate is lowered, all other interest rates in the economy also come down. The banks increase the supply of credit by reducing their lending rates. A reduction in the bank rate stimulates investment and the fall in the price level is arrested.
The Process of Bank Rate Influence
Regarding the process through which changes in the bank rate influence the supply of credit, the level of business activity and the price level, we can distinguish two approaches. One put forth by R.G. Hawtrey and the other one associated with J.M. Keynes.
In the opinion of Hawtrey, changes in the bank rate operate through changes in the short term rates of interest. These changes in the short term interest rates, in their turn, influence the cost of borrowing by businessmen and industrialists.
But, according to Lord Keynes, changes in bank rate become effective through changes in the long term interest rates as reflected by changes in the capital value of long term securities.
But, it should be noted that there is not much difference between the two approaches and hence they are complementary to each other.
Bank Rate Under the Gold Standard
Under the gold standard, bank rate was used primarily to set right the disequilibrium in the balance of payments of the country. When there was a deficit in the balance of payments and hence an outflow of gold, bank rate was raised to check the outflow of gold. This was done by attracting the inflow of short term capital into the country.
Conditions for the Success of the Bank Rate Policy
The efficacy of bank rate as an instrument of monetary management calls for the fulfillment of the following conditions:
(a) Close relationship between bank rate and other interest rates
It is necessary that the relationship between bank rate and the other interest in the economy should be close and direct. Changes in the rate should bring about similar and appropriate changes in the other interest rates in the economy. Otherwise the efficacy of bank rate will be limited. There is, therefore, the need for the existence of an integrated interest rate structure.
(b) Existence of an elastic economic system
The success of bank rate requires the existence of an elastic economic structure. That is, the entire economic system should be perfectly flexible to accommodate itself to changes in the bank rate. Changes in the bank rate should bring about similar and desirable changes in prices, costs, wages, output, profits, etc. The existence of a rigid economic structure will reduce the efficacy of bank rate.
(c) Existence of short term funds market
Another condition required for the success of bank rate policy is the existence of market for short term funds in the country. This will help to handle foreign as well as domestic funds that come up on account of changes in the interest rates, following changes in the bank rate.
Before the First World War, bank rate policy was very effective as an instrument of quantitative credit control because, the conditions necessary for the success of bank rate were there. But, after the war, the significance of bank rate began to wane because the post-war atmosphere was not conducive for the smooth and effective operation of the bank rate policy.
The Bank Rate Policy suffers from the following limitations:
(a) It has been argued that bank rate proves ineffective to combat boom and depression. During a period of boom, investment is interest inelastic.
Even if the bank rate is raised to any extent, investment activity will not be curbed, because during a period of boom, the marginal efficiency of capital will be very high and the entire business community will be caught in a sweep of optimism.
During depression, bank rate becomes ineffective following the general psychology of diffidence and pessimism among the business circles.
(b) The growth of non-banking financial intermediaries has proved an effective threat to the effectiveness of bank rate policy. It has been adequately established by the study of the Redcliffe Report and Gurley-Shaw, that the mushroom growth of non-banking financial intermediaries has belittled the significance of bank rate.
This is because changes in the bank rate immediately affect the rates of interest of the commercial banks only and the non-banking financial institutions are not subject to the direct control of the central bank. Hence, it is said that “the good boy is punished for
the actions of a bad boy.”
(c) The decline in the use of bills of exchange as credit instruments also has been responsible for the decline in the importance of bank rate.
(d) Further, of late, businessmen have found out alternative methods of business financing, self-financing, ploughing back the profits, public deposits, etc. Indeed, the role of commercial banks as suppliers of loanable funds has been decreasing in importance.
(e) Moreover, the economic structure has not been adequately responding itself to changes in the bank rate. After the war, all kinds of rigidities have crept into the economic system.
(f) The invention of alternative instruments of credit control also has accounted for the decline in the popularity of bank rate.
(g) Further, the dependence of the commercial bank on the central bank for loans also has decreased leading to the decline in getting the bills of exchange rediscounted by the central bank. In addition, there has been an increased liquidity in the assets of banks.
(h) Finally, the increase in the importance of fiscal policy following the Great Depression of 1930’s has also reduced the importance of bank take policy as a technique of credit control.
However, in spite of the above limitations that the bank rate policy is subject to, it would be wrong to undermine the significance of bank rate as a tool monetary management. Though, by itself, it may not yield the desirable results, but
will certainly prove effective when used with other instruments of credit control.
The scope for the use of bank rate by the central bank, therefore, cannot be completely ruled out. The bank rate has undergone a significant revival. Its significance in controlling inflation cannot be undermined.