Bank rate is the rate of interest which a central bank charges on the money borrowed (Loans) by commercial banks from the central bank. The bank rate is known by different names and different countries and the rate is decided according to the monetary policy of a country. The bank rate has a direct impact on the general population as it directly affects the rate at which the commercial banks will lend money to their clients. Hence, if the bank rate increases the rate which the commercial banks will quote to their clients will increase and vice versa. Bank rate is used by the central bank according to the performance of the country on certain parameters which indicate the macroeconomic scenario of a country, for example, if the unemployment is high, the central bank decreases the bank rate enabling the commercial banks to lend at cheaper rates.
A similar rate that is often confused with bank rate is Repo rate. Repo rate is charged for repurchasing the securities. These rates are largely similar however there are some differences which cannot be ignored. The bank rate does not keep any collaterals whereas in case of repo rate securities are kept as collateral which are to be repurchased at a pre-decided date.
In India, the bank rate is determined by the Reserve Bank of India which is the central bank of our country. The RBI also provides short term loan to commercial banks against securities at repo rate. The RBI changes these rates periodically however the period is not fixed rather the changes are decided according to the economy of the country. Both bank rate and repo rate affect the money supply in the economy and are used by the central bank as levers to control money supply and the monetary policy of the country.
What happens if the bank rate is increased?
- Increase in cost of borrowing – The interest payments on credit cards and loans and any such borrowings for commercial banks increases. This deters the people to borrow money from the bank and encourages them to save more. Overall consumption in the economy falls.
- More savings – Interest gained on the savings also increases and hence it acts as an incentive to save.
- Increases the value of the currency – Increased rate of interest entices the foreign investors to invest more in the country thereby making the home currency strong. This has an adverse effect on the exporters and positively affects the importers as people will be vary of buying against a currency which is stronger as they will have to pay more to procure the same products or services.
- Government debt interest payments increase – Government has to annually service the national debt and as the bank rate and repo rate increases these repayments become more and more.
- Slows growth of domestic businesses – A rise in rate of interest discourages businesses to take loans from banks.
All in all, a higher interest rate discourages consumption and investment and hence leads to fall in aggregate demand.
What happens if the bank rate is decreased?
- Encourages spending – As saving reaps smaller returns people are encouraged to spend and invest rather than save.
- Encourages borrowing – Borrowing cost decreases enabling consumers as well as firms to borrow more. This increases spending as well as investment.
- Encourages export – A lower interest rate devalues the currency. This attracts the importers of the foreign countries as they are able to buy more with the same amount of money. However, a small interest rate negatively affects importers in the home country.
Overall, a lower interest rate causes a rise in aggregate demand and hence increases aggregate output of a country. In context of a country a lower bank rate is beneficial for our country as India aims to become the largest exporter in the world.