Discount rate (bank rate), Managerial Economics

Discount Rate (Bank Rate)

This is the rate on central bank advances and is also called official discount rate or "minimum lending rate".  When commercial banks find themselves short of cash they may, instead of contracting bank deposits, go to the central bank, which can make additional cash available in its capacity as  "lender of last resort", to help the banks out of their difficulties.  The Central Bank can make cash available on a short-term basis in either of two ways; by lending cash directly, charging a rate of interest which is referred to as the official "discount rate", or by buying approved short-term securities from the commercial banks.  The central bank exercises regulatory powers as a lender of last resort by making this help both more expensive to get and more difficult to get.  It can do the former by charging a very high "penal" rate of interest, well above other short-term rates ruling in the money market.  Similarly, when it makes cash available by buying approved short-term securities, it can charge a high effective rate of interest by buying them at low prices.  The effective rate of interest charged when central bank buys securities (supplying cash) is in fact a re-discount rate, since the bank is buying securities which are already on the market but at a discount.

The significance of this rate of interest charged by the central bank in one way or the other to commercial banks, as a lender of last resort, is that if this rate goes up the commercial banks, who find that their costs of borrowing have increased, are likely to raise the rates of interest on their lending to businessman and other borrowers.  Other interest rates such as those charged by building societies on house mortgages, are then also likely to be pulled up.

Posted Date: 11/29/2012 4:50:53 AM | Location : United States







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