Meaning and Definition

The bank rate is the interest rate the central bank charges while making a loan to a commercial bank. Thus, the bank rate is essentially the lending rate of the central bank. The central bank has the power to increase or reduce the bank rate. The central bank often controls the volume of credit supplied by the commercial banks by changing the bank rate.

The bank (discount) rate is the minimum rate at which a commercial bank borrows from the central bank by (re) discounting bills of exchange or other eligible credit instruments (such as promissory notes). Since central bank is the lender of the last resource, i.e., the ultimate source of funds in the money market, the commercial banks approach the central bank for funds when they need it.

The commercial banks make loans by discounting bills of exchange presented to them by manufacturers and traders. Now if commercial banks do not receive sufficient deposit (with which to make loans), they approach the central bank for funds and the central bank re-discounts the bill of exchange held by commercial (member) banks. The rate at which the central bank re-discounts the bills of other eligible papers presented by the commercial banks is known as the bank (discount) rate. A rise in the bank rate by the central bank implies that the commercial banks will have to pay higher interest rates while taking loans from the central bank. They will, therefore, be forced to charge higher rates of interest while making loans.

A related point may also be noted in this context. When the central bank raises the bank rate, the commercial banks are forced to pay higher interest rates on the deposits they accept from the public. This also explains why the commercial banks charge higher rate of interest, while making loans and advances, when the bank rate rises. There is, in fact, a mechanical relation between the bank rate (at which a commercial bank borrows funds) and the market rate (at which a bank lends). This means that as and when the bank rate increases the market rates of interest automatically raise. The converse is also true. When the central bank reduces the bank rate the commercial banks reduce their lending rates. This means that the market rates of interest automatically fall.

When the market rates of interest go up, business firms and consumers of durable goods will be less willing to take loans from banks than before. When the rate of interest rises, business people finds it less profitable to borrow funds for investment purposes. The banks are also less willing to make loans. It is because if they make more loans they have to approach the central bank for funds. And the central bank will charge higher rate of interest from commercial banks for making loan. So two things happen when the bank rate goes up. First, the market rates of interest rises and the demand for bank loans falls. Secondly, commercial banks have to obtain funds from the central bank by paying higher rates of interest. For both the reasons the commercial banks make less loans when the bank rate increases. The converse is also true. The commercial banks make more loans in the event of a fall in the bank rate. This explains why the bank rate is raised during inflation and is lowered during deflation (recession).

Limitations of the Bank Rate Policy

However, for the bank rate policy to be effective in controlling credit (and thus inflation), certain conditions have to be satisfied. This means that there are certain limitations of bank rate policy as an instrument of credit control; the following points may be noted in this context -

• Excess reserves: It is normally assumed that when the central bank raises the bank rate, the commercial banks also increase their lending rates. This is true only when the commercial banks are able to lend as much as they can at the existing rates of interest, i.e., there is sufficient demand for bank loans. But if commercial banks have excess reserves, they cannot raise their lending rates even if the bank rate is raised. They instead keep their lending rates unchanged or even reduce the rates in order to encourage business people and consumers to borrow more funds. In such situations commercial banks need not borrow any extra funds from the central bank and thus, the bank rate policy will not be much effective.
• Interest in elasticity of investment: Commercial banks may raise their lending rates in the event of a rise in the bank rate. But if investment expenditure (on plant, equipment and machinery) is not much sensitive to interest rate changes, the demand for bank loans may not fall much. As a result, the bank rate policy may not be very effective. This means that in an inflationary situation, the rate of interest has to be raised to a very high level in order to have desirable effects.
• General economic conditions: The demand for bank loans by business people depends not so much on the cost and availability of credit. It depends largely on the general economic situation prevailing in the economy and on the investment (profit) prospects. When the economy is in deep depression, profit prospects are bleak. In such a situation, the business people would be reluctant to borrow even at a lower rate of interest. This is why Keynes argued that monetary policy losses its effectiveness during depression. It is easier to restrict the demand for bank loans than to raise it. (This is known as the cyclical asymmetry of monetary policy).
• Lack of well-developed money market: In reality we find various reasons for investment not responding much to changes in interest rates. Large investment projects take a long time to complete and can neither be cut off nor accelerated when interest rates change. Projects in manufacturing industries typically have quite a short payback period, which implies a high annual depreciation charge before the asset is written off. This renders the difference between one amount of interest and another rather a small proportion of all the capital charges. The rate of return which a project will earn cannot be known exactly in advance, in the face of all the uncertainties which businesses face; instead, a range of estimates of possible rates of return is considered, and given this range, an alteration in the rate of interest is not of much significance.