The bank rate, also known as the discount rate, is the rate payable by commercial banks on the loans or rediscount rate of the Reserve Bank.
A change in bank rate affects the other market rates of interest. An increase in bank rate leads to an increase in other rates of interest, and conversely, a decrease in bank rate results in a fall in other rates of interest.
A deliberate manipulation of the bank rate by the Reserve Bank to influence the flow of credit created by the commercial banks is known as bank rate policy. It does so by affecting the demand for credit, the cost of the credit and the availability of the credit.
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An increase in bank rate results in an increase in the cost of credit, this is expected to lead to a contraction in demand for credit. In as much as bank credit is an important component of aggregate money supply in the economy, a contraction in demand for credit consequent on an increase in the cost of credit restricts the total availability of money in the economy, and hence may prove an anti-inflationary measure of control.
Likewise, a fall in the bank rate causes other rates of interest to come down. The cost of credit falls, i.e., credit becomes cheaper. Cheap credit may induce a higher demand both for investment and consumption purposes. More money through increased flow of credit comes into circulation. A fall in bank rate may, thus, prove an anti-deflationary instrument of control.
The effectiveness of bank rate as an instrument of control is, however, restricted primarily by the fact that both in inflationary and recessionary conditions, the cost of credit may not be a very significant factor influencing the investment decisions of the firms.
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Open Market Operations:
Open market operations refer to the sale and purchase of securities by the Reserve Bank to the commercial banks. A sale of securities by the Reserve Bank, i.e., the purchase of securities by the commercial banks, results in a fall in the total cash reserves of the latter.
A fall in the total cash reserves is tantamount to a cut in the credit creation power of the commercial banks. With reduced cash reserves at their command the commercial banks can only create lower volume of credit. Thus, a sale of securities by the Reserve bank serves as an anti- inflationary measure of control.
Likewise, a purchase of securities by the Reserve Bank results in more cash flowing to the commercial banks. With increased cash in their hands the commercial banks can create more credit, and make more finance available. Thus, purchase of securities may work as an anti- deflationary measure of control.
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The Reserve Bank of India has frequently resorted to the sale of government securities to which the commercial banks have been generously contributing. Thus, open market operations in India have served, on the one hand as an instrument to make available more budgetary resources and on the other as an instrument to siphon off the excess liquidity in the system.
Variable Reserve Ratios:
Variable reserve ratios refer to that proportion of bank deposits which the commercial banks are required to keep in the form of cash to ensure liquidity for the credit created by them.
The Reserve Bank of India is empowered to change the reserve requirements of the commercial banks. The Reserve Bank employs two types of reserve ratios for this purpose, viz., the Statutory Liquidity Ratio (SLR) arid the Cash Reserve Ratio (CRR).
A rise in the cash reserve ratio results in a fall in the value of the deposit multiplier. Conversely, a fall in the cash reserve ratio leads to a rise in the value of the deposit multiplier. A fall in the value of deposit multiplier amounts to a contraction in the availability of credit, and thus, it may serve as an anti-inflationary measure.
A rise in the value of deposit multiplier, on the other hand, amounts to the fact that the commercial banks can create more credit, and make available more finance for consumption and investment expenditure. A fall in the reserve ratios may, thus, work as anti-deflationary method of monetary control.
The statutory liquidity ratio refers to that proportion of aggregate deposits which the commercial banks are required to keep with themselves in a liquid form. The commercial banks generally make use of this money to purchase the government securities. Thus, the statutory liquidity ratio,
on the one hand, is used to siphon off the excess liquidity of the banking system, and on the other, it is used to mobilise revenue for the government. The Reserve Bank of India is empowered to raise this ratio upto 40 per cent of aggregate deposits of commercial banks.