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Indian Economic Policy
Notes The bank rate policy was first adopted by the Bank of England in 1839. It was the only and the
most widely used weapon of credit control until the open market operation, first used in 1922
in the US, emerged as a more powerful instrument of monetary control. In India, the RBI has
been using the bank rate as monetary control measure, though infrequently, since its inception
in 1935. The bank rate remained constant at 3% till 1950. In 1951, it was increased to 3.5% and to
4% in 1956, and remained in force till 1962. In the subsequent year, the bank rate was increased
more frequently and it was raised to 12% in 1992 and was maintained till 1997. With growing
need for credit facility with economy growing at 5-6% and also decreasing rate of inflation, the
bank rate was reduced gradually to 6.5% in 2001, which was lowest since 1973. The bank rate
was reduced to 6 percent in 2004 which was maintained till 2006-07. However, bank rate was
raised to 7.5 percent in 2008 with the objective of controlling inflation which was as high as 11.5
percent in July 2008.
The working of the bank rate policy is simple. When the central bank changes the bank rate,
commercial banks change their own discount rate accordingly with a difference of generally
one percent. The change in the bank rate affects the flow of bank credit to the public. For example,
if the central bank wants to reduce the money supply by reducing the flow of credit from the
banks to the public, it will raise the bank rate. Raising bank rate reduces credit flow in three
ways.
One, a rise in the bank rate (virtually the interest rate) reduces the net worth of the government
bonds (the Treasury Bills and Promissory Notes) against which commercial banks borrow funds
from the central bank. This reduces commercial banks’ capacity to borrow from the central
bank. As a result, commercial banks find it difficult to maintain a high cash reserve. This reduces
the credit creation capacity of the commercial banks. So the flow of credit is reduced.
Two, when the central bank raises its bank rate, commercial banks raise their discount rate too.
Rise in the discount rate raises the cost of bank credit which discourages business firms to get
their bill of exchange discounted. Also, a rise in the bank rate pushes the market interest rate
structure up. If demand for credit is interest-elastic, the demand for funds decreases too.
Three, bankers’ lending rate is quickly adjusted to deposit rates. Therefore, a rise in the bank
rate causes a rise in the deposit rate. Therefore, savings flow into the banks in the form of time
deposits and money with public decreases. This is called deposit mobilization effect.
Exactly reverse happens when the central bank cuts down the bank rate.
Selective Credit Control Measures
The general credit control methods of monetary controls affect, when they are effective, the entire credit
market in the same direction. They lead either to expansion or to contraction of the total credit as
intended by the monetary authorities. Besides, their impact on all the sectors of the economy is uniform.
This may not be always desirable or intended by the policy-makers. The monetary authorities are
often required to take policy actions for (a) rationing of credit for different sectors of the economy, (b)
diverting the flow of credit from the non-priority sectors to the priority sectors, and (c) curbing
speculative tendency based on the availability of bank credit. These objectives of credit control are
not well served by the quantitative measures of credit control. The monetary authorities resort,
therefore, to qualitative or selective credit controls. Some of the common selective credit controls
are discussed below.
(i) Credit Rationing : When there is a shortage of institutional credit available for the business
sector, the highly developed and financially strong sectors and industries tend to capture the
lion’s share in the total institutional credit. As a result, priority sectors and essential industries
are starved of necessary funds, while the bank credit goes to the non-priority sectors. In order
to curb this tendency, the central bank resorts to credit rationing measures. Generally, two
measures are adopted : (a) imposition of upper limits on the credit available to well-developed
industries and large-scale firms, and (b) charging a higher or progressive interest rate on bank
loans beyond a certain limit. This is done with a view to making bank credit available to the
essential and priority sectors.
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