How do changes in bank rate affect the money supply in an economy? Explain. (2024)

Bank Rate is the rate of interest at which the Central Bank lends money to the commercial banks in emergency, acting as "lending of the last resort". The purpose of change in bank rate is to change the cost of borrowing from the Central Bank.

(i) An increase in the bank rate increases the cost of borrowing from the Central Bank. Therefore, if the Central Bank increases the bank rate, the commercial banks also increase the rate at which they lend to the public and business firms. It makes borrowings by the people costly. This will discourage them from taking loans. This also reduces the ability of commercial banks to create credit. Thus volume of credit and money supply will decrease in the economy.

(ii) A decrease in the bank rate will reduce the cost of borrowings of commercial banks from the Central Bank. The commercial banks will further reduce their lending rates increasing the volume of credit and money supply in the economy. The decrease in bank rate induces people to borrow more from the bank and this will have a positive effect on the money supply.