Limitation of bank rate, Managerial Economics

Limitation

The degree or success with which the central bank can use its bank rate policy to control the total credit in the economy depends upon the interest elasticity of investment demand. During boom the demand for bank credit by the business community may be highly interest inelastic. When the entrepreneurs are over optimistic and consequently the marginal productivity of investment in high. The demand for bank credit cannot be curtailed simply by raising the bank rate by the central bank . if the investors expect that the value of their investment will appreciate, say by 10 per cent annum then even a rise of a as high as 10 per cent per annum in the money interest rate will not deter them from borrowing from the commercial banks. Moreover, in many business undertakings interest rate constitutes a negligible proportion of the total unit cost of production . consequently , for such business the demand for bank credit is highly interest inelastic. Although in the long period the bank rate is bound to influence the stock market and the business yield expectations, but it may be too late to cheek evil when the seeds of destruction have been already sown.

The bank rate policy proves more ineffective during depression than during the boom. Any depression involves tedious readjustments of one type or the other. Serious depression gives a sharp blow to business confidence which only a considerable time factor can revive. Consequently, at this time the demand for bank credit become highly interest inelastic. Businessmen do not borrow even at the maximum facilities provided by the commercial banks. When sales are falling off quickly an idle plant capacity in increasing over the entire community, the investors cannot be easily persuaded to increase or even to continue the flow of their borrowing . Nobody will install any new plant for a remote and uncertain demand. Even if the interest rate falls to zero, or even becomes negative (which is not possible ) no inducement to invest may be caused. If the fall in prices is expected to continue, no conceivable fall in its bank rate by the central bank and through it in the lending rates of the commercial bank will initiate recovery in the economy in the economy. Thus the bank rate policy suffers from serious limitations and central bank cannot eliminate the occurrence of both and s slump from the economy merely by raising or lowering the bank rate.

Posted Date: 12/1/2012 7:07:32 AM | Location : United States







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