Bank Rate (BR) or Discount Rate and Inflation
Bank rate (BR) is one of the most effective weapons employed by almost all central banks to control credit in the financial system. There is a direct relation between Bank Rate and Market Rate. It is widely assumed that a change in Bank Rate brings corresponding change in the Market Rate too.
What is the definition of Bank Rate?
Bank Rate is the rate at which the central bank re-discounts the eligible bills with commercial banks or extends advance against approved securities to commercial banks. The rate is also referred Discount Rate. As per the simple definition, Bank Rate is the rate of interest charged by the central bank while extending financial accommodation or assistance to commercial banks. Bank Rate is defined under Section 49 of RBI Act 1934.
In India, the RBI used to change Bank Rate frequently to stabilize the economy. It is extremely difficult to predict the relation between Bank Rate and amount of bank credit. However, it can be stated without doubt that Bank Rate has direct impact on the long term lending activities. The RBI can control the volume of credit by making variations in Bank Rate. The cost and the availability of credit to commercial banks too can be influenced by the central bank through changes in Bank Rate or Discount Rate.
Variation in Bank Rate, Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio(SLR) have been three tools that are frequently being used by RBI for controlling availability of credit, interest rate and liquidity in market. From February 2012, Bank Rate is realigned with the Marginal Standing Facility (MSF) by the RBI.
Bank Rate (BR) during Inflation and deflation
During inflationary conditions, the money supply in market is on higher side. To control liquidity, the central Bank will increase the Bank Rate. This increases the market rate too and borrowing becomes costlier for a borrower. The increased borrowing cost deters business men, entrepreneurs, traders, individuals etc from borrowing. Thus the RBI eliminates excess supply of money in the financial system through Bank Rate hike. Here, the central bank follows ‘Dear Money Policy’ or ‘Tight Monetary Policy.’
During deflation/ depression, the RBI reduces Bank Rate to make credit cheaper and thereby inject liquidity into the system. In such a scenario, to boost economic activities, the central bank follows ‘Cheap Money Policy’ or ‘Cheap Monetary Policy’.
The impact of Bank Rate on market rate
In an ideal situation, change in Bank Rate shall bring corresponding change in market rate too. But often, the change in Bank Rate fails to exactly transmit the change to market due to various facts. The effectiveness of interest transmission depends on the following aspects too:
The degree of dependency of banking system on borrowed funds
The state of demand for bank loans
Supply of funds from other sources
Availability of surplus cash with commercial banks`
Limited popularity for the bill rediscounting process
Even if the transmission is not 100% effective, central banks succeeds in conveying their stance to market through Bank Rate change.
