9 Limitations of bank rate policy
bank rate policy
The bank rate or the discount rate is the rate fixed by the central bank at which it rediscounts first class bills of exchange and government securities held by the commercial bank. The bank rate is the interest rate charged by the central bank at which it provides rediscount to banks through the discount window. The central bank controls credit by making variations in the bank.
If the need of the economy is to expand credit, the central bank lowers the bank rate. Borrowing from the central bank become cheap and easy. So the commercial banks will borrow more. They will, in turn, advance loans to customers at a lower rate. The market rate of interest will be reduced. This encourages business activity, and expansion of credit follows which encourage the rise in price.
The opposite happens when credit is to be contracted in the economy. The efficacy of the bank rate policy as an instrument of controlling credit is limited by the following factors:
1. Market rate do not change with bank rate;
The success of the bank rate policy depends upon the extent to which other market rates of interest change along with the bank rate. the theory of bank rate policy pre suppose that other rates of interest prevailing in the money market cahnege in the direction of the change in the bank rate.
If this condition is not satisfied, the bank rate policy will be totally ineffective as an instrument of credit control.
2. Wages cost and prices not elastic;
The success of the bank rate policy requires elasticity not only in interest rates but also in wages, cost and prices. it implies that when suppose the bank rate is raised, wages, cost and prices should automatically adjust themselves to a lower level. But this was possible only under gold standard. Now days the emergence of strong trade unions has made wages rigid during deflationary trends. And they also lag behind when there are inflationary tendencies because it takes time for unions to get a wages rise from employers. So the bank rate policy cannot be a success in a rigid society.
3. Banks do not approach central bank;
The effectiveness of the bank rate policy as a tool of credit is also limited by the behavior of the commercial bank. It is only if the commercial banks approach the central bank for rediscounting facilities that this policy can be a success. But the banks keep with them large amounts of liquid assets and do not find it necessary to approach the central bank for financial help.
4. Bills of exchange not used;
As a corollary to the above, the effectiveness of the bank rate policy depends on the existence of eligible bills of exchange. In recent years, the bill of exchange as an instrument of financial commerce and trade has fallen into disuse. Businessmen, women and banks prefer cash credit and overdraft. This makes the bank rate policy less effective for controlling credit in the country.
5. Pessimism or optimism;
The efficacy of the bank rate policy also depends on waves of pessimism or optimism among businessmen. If the bank rate is raised, they will continue to borrow even at a higher rate of interest if there are boom conditions in the economy, and prices are expected to rise further.
On the other hand, a reduction in the bank rate will not induce them to borrow during periods of falling prices. Thus businessmen are not very sensitive to changes in interest rates and they are influenced more by business expectations.
6. Power to control deflation limited;
Another limitation of the bank rate policy is that the power of a central bank to force a reduction the market rates of interest is limited. For instance, a lowering of bank rate below 3 percent will not lead to a decline in the market rates of interest below 3 percent. So the bank rate policy is ineffective in controlling deflation. It may, however, control inflationary tendencies by forcing an increase in the market rates of interest.
7. Level of bank rate in relation to market rate;
The efficacy of the discount rate policy as an instrument of credit control depends upon its level in relation to the market rate. If in a boom the bank rate is not raised to such an extent as to make borrowing costly from the central bank, and it is not lowered during a recession so as to make borrowing cheaper from it, it would have a destabilizing effect on the economic activities.
8. Non discriminatory;
The bank rate policy is non discriminatory because it does not distinguish between productive and unproductive economic activities in the country.
9. Not successful in controlling BOP disequilibrium;
The bank rate policy is not effective in controlling balance of payments disequilibrium in a country because it requires the removal of all restrictions on foreign exchange and movements of international capital.
Conclusion;
The above points have led the majority of economist and experts in the field of economics and management to conclude that the power to alter the bank rate is an extremely weak weapon of monetary management. Friedman a renounced economist even went to the extent of proposing outright elimination of the “discount window” itself
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