Question

Elaborate, how does a Central Bank stabilize money supply through ‘Bank Rate’.

Answer 1

The bank rate is the rate at which the Central Bank lends money to commercial banks as a lender of last resort. During inflation, when it is necessary to reduce the supply of credit, the bank rate is increased. This makes borrowing from the Central Bank more expensive for commercial banks, reducing their reserves and limiting their ability to create credit. When the bank rate rises, market interest rates also increase, which discourages borrowing from commercial banks. As a result, the overall supply of credit in the economy declines.

In contrast, to tackle deflation, the bank rate is reduced in order to increase the availability of credit in the economy.