open market operations vs. bank rate policy

 

Open market operations vs. bank rate policy

 

open market operation vs. bank rate policy

The question arises whether the bank rate is more effective as an instrument of credit control or open markets operations.

 

1.      The bank rate policy influences the cost and supply of commercial bank credit, while open market operations affect the cash reserves of the commercial banks. Changes in the bank rate affect the creation power of the commercial banks only if they rediscount their bills with the central bank. If the bank don not feel the necessity of availing rediscounting facilities of the central bank, a rise in the bank rate will have no effect on the commercial banks. On the other hand, the lending power of the commercial banks is directly related to their cash reserves, and open, market operations influences their cash reserve directly and immediately thereby affecting their credit creation power.

2.      “from the standpoint of their strategic value to the central bank, open market operations posses a degree of superiority over rediscount policy because of the fact that initiative is in the hands of monetary authority in the case of the former, whereas bank rate policy is passive in the sense that its effectiveness depends on the responses of commercial banks and their customers to changes in bank rates.

3.      Open market operations are flexible with respect to timing and magnitude as compared with the bank rate policy. They are carried on continuously and do not have any destabilizing effects on the economy that accompany changes in the bank rate.

4.      It is further argued that since bank rate changes have destabilizing effects on the economy, this policy should be used to correct permanent maladjustments in the money market rather than temporary maladjustment. On the other hand, open market policy can be used for correcting both temporary and permanent maladjustment in the money market.

 

Conclusion:

 

But the experience of developed countries like united state of America and the united kingdom tells us that these two policies are not competitive but complementary to each other, if they are supplemented, they can control credit more effective than individual. For instance, if the central bank raise the discount rate for the purpose of contracting credit, it will not be effective when the commercial banks have large excess reserve with them. They will continue to expand credit irrespective of the rise in the bank rate. But if the central bank first draws away to itself the excess reserve of the commercial banks by the sale of securities and then raises the bank rate, it will have the effect of contracting credit unless the bank rate is also raised. The sale of securities by the central bank will reduce the cash reserve of commercial banks but if the discount rate is low the latter will get funds from the discount window of the central bank. So for an effective policy of credit control, bank rate policy and open market operations should judiciously supplement.