Question

Explain how ‘bank rate' is helpful in controlling credit creation?

Explain how the bank rate can be used by the Central Bank to control credit.

Answer 1

Bank rate is the rate at which the central bank provides credit to commercial banks. An increase or decrease in the bank rate leads to an increase or decrease in the market rate of interest. Thereby the cost of credit changes in the market. During inflation, an increase in the bank rate increases the cost of capital, which reduces the flow of credit.

Answer 2

The bank rate, also known as the discount rate, is the minimum rate of interest at which the central bank lends money to commercial banks or rediscounts approved bills of exchange and government securities held by them. It is one of the oldest and most traditional tools used for regulating bank credit.

This rate is not fixed; the central bank adjusts it periodically based on economic conditions. By altering the bank rate, the central bank can influence the overall volume of credit in the economy. The working mechanism of the bank rate is straightforward. There is a close link between the bank rate and the interest rates that commercial banks charge their customers.

When the bank rate changes, it usually leads to a corresponding adjustment in the lending rates of commercial banks. These lending rates directly affect how much credit businesses and individuals borrow for investment and other economic activities. Thus, by modifying the bank rate, the central bank can indirectly control both the quantity and cost of credit by influencing the interest rates applied by commercial banks.