Limitations of Bank Rate Policy
Limitations of bank rate policy
For the successful working of this policy, a little reflection will show that a number of circumstances have to be satisfied:—
(i) Efficacy of bank rate in regulating credit needs a closer association among the bank rate and other rates of interest in the market. Changes in the bank rate must be followed by changes in the market rates. This presupposes the existence of a highly organized money market. Unfortunately, most countries do not have organized money markets.
(ii) No surplus reserves. The requirement for commercial banks to advance the Reserve bank for rediscounting is a significant aspect in shaping the thriving functioning of the bank rate. But commercial banks will not require approaching the Reserve bank when they have sufficient liquid assets at their disposal, i.e, when they have enough excess reserves.
(iii) The proper functioning of the bank rate policy presumes a flexible economic organization so that alterations in credit circumstances ought to lead to equivalent changes in rents, wages, trade, production, etc.
(iv) The psychological reactions to a change in the bank rate should also be considered for the effectiveness of the bank rate policy. If in a boom period, businessmen are unduly optimistic, their demand for credit will be interest-inelastic and the bank rate will be ineffective. Similarly, during depression, the pessimism of businessmen will not consider low interest rate as incentive. It is true that businessmen are influenced by rates of interest, but they are more influenced by business expectations.
(v) The axiom that a rise in bank rate, and thus a rise in interest rates payable on deposits by commercial banks, will cause an increase in bank deposits is questionable. A large majority of people save with precautionary motive and their savings depend upon their capacity to save, i.e., their income. These savers do not look for a rise in the interest rates on deposits, but they deposit usually with banks for the purpose of safety. Thus, it is actually the increase in income rather than interest rates that promotes savings by the people and thus augments bank deposits.
(vi) The eligibility for rediscounting bills by the central bank presupposes, in the operation of bank rate policy, a soundly developed bill market. Under-developed bill markets, thus, set a limitation on bank rate operations.
Political Influence on Bank Rate Policies
There can also be political influences on bank rate policies. For instance, in the United States, the President appoints the Fed chairman, otherwise the chairmen of the Federal Reserve and the Federal Reserve banks around the country.
The Federal Reserve can lower and raise interest rates which affect all of us. With a raise of interest rates, interest on credit cards, home loans and all other interest bearing loans can go up as they are tied to the prime rate.
Stock markets and stock market traders around the world pay attention to certain countries Federal Reserve Banks for a clue to economic conditions.