Bank Rate or Discount Rate – Bank Rate Policy Defined

Bank Rate or Discount Rate is one of the earliest methods of general credit control developed by the Bank of England and it was considered an effective method till the outbreak of First World War. After the war, Bank of England developed other methods as it found the bank rate policy to be not so effective. The essence of discount rate policy that commercial banks approach the central bank whenever they are in need of financial accommodation. They get the necessary assistance by re-discounting the eligible bills and other securities. The Central bank would re-discount these instruments at a rate which directly determines the volume of funds which the commercial banks can get through this method of financial accommodation. A revision of this re-discounting rate by the central bank will necessitate the commercial banks to change their rate of discounting of eligible bills and securities. As a result the businessmen will be encouraged or discouraged in approaching the commercial banks to get financial accommodation. Hence, it could be understood that the re-discounting rate is very much linked with all the other market rates and discounting rate.

In order to understand the process let us take an example. Suppose a commercial bank has a discounted trade bill worth 2000 USD at 15% and given holder of he bill 1700 USD. Suppose the commercial bank is in need of funds it can approach the Central bank and get the same bill re-discounted. Suppose the re-discounting rate 10%, then the commercial bank will get after re-discounting the bill 1800 USD. Now it should be noted that the rate at which the Central bank discounts the eligible bills already discounted by the commercial banks is called re-discount rate or bank rate. The discount rate refers to the rate at which the commercial bank discounts the bills of the businessmen. The bank rate or the re-discount rate and the discount rate are very closely related. Suppose there is inflationary situation prevailing in the economy and the Central bank wants to reduce the purchasing power. It will then raise the bank rate. Suppose the bank rate is raised from 10% to 15% correspondingly the commercial banks will also raise their discounting rate from 15% to say 22% As a result the commercial bank will get only 1700 USD after re-discounting the bill and the businessman will get only 1560 USD after discounting the bill. Since the rate of discount is very high or the cost of borrowing in the market becomes high, the business men will start borrowing less and so volume of credit will come down. This will lead to decline in economic activity and the price level will fall down. Similarly during deflationary situation, the downward revision of bank rate will bring down the discount rate and encourage more borrowing and expand the economic activity and allow the price level to go up helping the economy to recover. At a lower bank rate and discount rate the bank credit is made cheaper and borrowing is attractive.

There are two interpretations available in explaining the process of the bank rate policy. One was developed by Hawtrey and the other by Keynes.

  1. According to Hawtrey, the interest changes constitute major part of the cost of holding and that businessmen are very much sensitive to changes in interest rate. He explained that any change in bank rate will bring about corresponding changes in short term interest rates. Suppose the bank rate is raised, the short term rate of interest will go up making the bank credit costly and discouraging the business men from borrowing and investing. This will lead to shrinking of business activity affecting employment and income. When the employment goes down, the income goes down, bringing down the purchasing power, thereby the demand for goods will fall causing price to fall. Similarly a rise in bank rate will have opposite effect.
  2. Keynes, on the other hand, was of the opinion that any change in bank rate will affect the short term interest rates and bring down the capital value of old long term securities as the new short term securities carry higher return. So there will be diversion of investment from long period to short period securities. To avoid this diversion, the long term rates should be revised upwards which will make borrowing costly. As there will be no corresponding upward revision in the marginal efficiency of capital of long term investment the businessmen will be forced to reduce their investment which will mean fall in output, employment and income. As a result the aggregate demand will fall down and the inflationary tendency will be arrested. Both these interpretations are correct as one approaches the problem of inflation through short period securities and the other through long term securities.

The effectiveness of the bank rate policy in controlling the credit depends on the following conditions:

  1. The bank rate and the other interest rates should be very closely interconnected, as otherwise the desired effect through manipulation of bank rate cannot be achieved.
  2. The economic structure of the country should be elastic. This means that wages, costs and prices should be flexible so that they cart change depending upon the changes in bank rate.
  3. The existence of well developed and well organized short term funds market is the next requirement.

The bank rate policy in practice has not been very effective because of the following reasons:

  1. The conditions for the success of the bank rate policy are rarely met in practice, making it ineffective.
  2. Businessmen and industrialists are found to be less sensitive to changes in interest rate as they change their policies depending upon the business prospects and adversities.
  3. Bank rate has been found to be non-effective in controlling deflation, as mere reduction in bank rate and through that making credit cheaper does not enthuse the investors to increase their investment.
  4. There exists conflict between the internal and external effects of the bank rate policy. For instance, when domestic borrowing becomes costly, international borrowing may become cheaper defeating the purpose changing the bank rate.
  5. Commercial banks are found to be increasingly less dependent on the central bank and so any change in bank rate fails to bring the necessary effect.
  6. Bank rate policy affects both the productive as well as unproductive activities in the same way; so it is not advisable.
  7. The increasing importance given to the fiscal policy, especially after Keynes has made the bank rate less useful.
  8. The changing pattern of business finance with over emphasis on ploughing back of profits, building up reserve funds, etc have made investors relying less on commercial bank credit and as a result bank rate policy has become ineffective.
  9. The formulation of other methods of credit control has also led to the decline in importance of bank rate policy.
  10. Financing through discounting of bills or other negotiable instruments has become outdated as there are other modern methods of financing and so bank rate policy is less effective.

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