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Unit 14: Financial Regulations

changes in interest rates. In particular, changes in interest rates and these in turn influence Notes
investment and income in the economy influence the holding of inventories and fixed assets
formation.
On the external front, bank rate changes influences inflow and outflow of funds of both short
term and long term nature, namely, those for speculative and investment purposes. But in India
due to the prevailing all-pervading exchange regulations, these external effects are limited for
all practical purposes.

Limitations of Bank Rate Policy

The efficacy of the bank rate policy would depend on the following factors:
1. Link with Market Rates of Interest: The link between the bank rate and other interest
rates should be strong and close so that changes in the bank rate would lead to consequent
changes in the other interest rates in the economy. If the markets were not close and
integrated, this would not be possible.
2. Extent of Cash Reserves: If there are excess reserves with the banks and there is no need to
borrow from the Central Bank, then the bank rate changes would not percolate to other
segments of the money market and its effectiveness will be limited.

3. Interest Elasticity of Investment: If the interest elasticity of investment is low and the
demand for credit is interest rate policy or bank rate changes would not affect significantly
the real economic variables such as investment, income and employment.
4. Flexibility and Cost and Prices: For the bank rate policy to work effectively there should
be flexibility in cost and prices and interest cost should be a significant variable in the cost
of production of industries.

5. Business Psychology: For effectiveness of the bank rate policy, particularly in a period of
depression, it should be capable of influencing the business psychology on which
investment outlays would depend generally. As the bank rate cannot influence this
psychology in depressed conditions, it is said that the bank rate policy may work during
an inflationary period but not at times of depression.
6. Extent of Money Market Development: For the bank rate policy to work, there should be
a developed bill or money market, in which the Central Bank operates. In the absence of
eligible bill for discount or because of undeveloped money markets as is India, the efficiency
of bank rate policy will be limited.

Efficacy of Bank Rate Policy in India

1. The efficacy of bank policy in India is limited because of the multiplicity of refinance rates
and the relative low elasticity of savings and investments to interest rates. This is due to
the fact that the bulk of investments in India is in the public sector and by the government.

2. As an indicator of the policy, the bank rate is, harbinger of changes in credit policy. It no
doubt influences the cost and availability of bank funds. So far as the organized financial
sector is concerned, changes in other interest rates follow the changes in the bank rate. In
India, deposit rates and lending rates of banks, including the various rates charged by
banks on loans for different purposes, are controlled by the RBI. The government in
consultation with the RBI fixes the interest rates charged by financial institutions and post
officers. The short term and long-term rates and whole spectrum of interest rates change

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