Previous Year Question
The lowering of Bank Rate by the Reserve Bank of India leads to
more liquidity in the market
less liquidity in the market
no change in the liquidity in the market
mobilisation of more deposits by commercial banks
Correct Answer: A
Detailed Solution
The Bank Rate is the standard rate at which the Reserve Bank of India is prepared to buy or rediscount bills of exchange or other eligible commercial paper. Traditionally, it has indicated the direction of the central bank’s longer-term credit and monetary policy.
A reduction in the Bank Rate constitutes an expansionary monetary measure. Its transmission can be understood as follows:
It signals a reduction in the cost of obtaining funds from the Reserve Bank.
The funding cost of commercial banks is expected to decline.
Commercial banks may reduce their lending rates.
Cheaper credit increases the demand for loans from industries, businesses and consumers.
Increased bank lending expands credit creation and the availability of money.
Consequently, market liquidity increases, supporting investment and economic activity.
Therefore, lowering the Bank Rate ordinarily results in more liquidity in the market.
Option-wise examination:
Option (a) is correct: A lower Bank Rate encourages credit expansion and increases the availability of money and credit in the market.
Option (b) is incorrect: A rise, rather than a reduction, in the Bank Rate is normally used to reduce liquidity by making credit more expensive.
Option (c) is incorrect: A change in the Bank Rate can influence monetary conditions, the cost of credit and market liquidity.
Option (d) is incorrect: Deposit mobilisation primarily depends on deposit interest rates, income, saving behaviour and the attractiveness of financial products. The direct purpose of lowering the Bank Rate is to encourage credit and liquidity, not to mobilise more deposits.
Reverse situation: An increase in the Bank Rate tends to raise the cost of funds, make loans more expensive, restrain credit creation and reduce market liquidity. Such a measure may be used to contain inflationary pressures.
Important fact: In February 2012, the RBI realigned the Bank Rate with the Marginal Standing Facility Rate. In the present monetary framework, the Repo Rate is the principal policy rate, while the Bank Rate also serves as a reference rate for certain statutory and penal interest provisions. The present question is based on the traditional monetary effect of the Bank Rate.