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The central bank lending rate is the interest rate that commercial banks pay when they borrow money directly from the central bank. It acts like a steering wheel for the economy, allowing the central bank to influence both short-term and long-term interest rates throughout the financial system.
By adjusting the central bank lending rate, the central bank can indirectly control borrowing costs across the entire economy. When the central bank wants to boost economic activity, it reduces its lending rate. This makes it cheaper for commercial banks to borrow money. In turn, commercial banks are more likely to offer lower interest rates to businesses and consumers, encouraging them to borrow and spend more. This increase in spending (aggregate demand) stimulates economic growth.
Conversely, if the economy is growing too fast or inflation is rising, the central bank can raise its lending rate. This makes borrowing more expensive for commercial banks, who then typically raise their own interest rates. Higher borrowing costs discourage businesses and consumers from borrowing and spending as much, which helps to cool down the economy and bring inflation under control.
The central bank’s goal is to maintain a stable and healthy economy. By adjusting the central bank lending rate, they can influence factors like economic growth, inflation, and unemployment. This helps to create a more predictable and prosperous environment for businesses and consumers alike.
How the central bank lending rate works
An interest rate represents the cost of borrowing money, essentially a fee paid to the lender for the use of their money. Conversely, a higher interest rate means a borrower pays more for that privilege, while a lower interest rate translates to cheaper borrowing costs.
The central bank acts like an economic conductor, using the lending rate as a key instrument to ensure stability. This is crucial because fluctuations in the business cycle, the natural rise and fall of economic activity, can sometimes lead to extreme situations like hyperinflation (rapid price increases) or recession (economic decline). To prevent these scenarios, the central bank uses the lending rate alongside other tools like open market operations and reserve requirements to steer the economy in the right direction.
Raising the central bank lending rate
When inflationary pressures are too high, the economy starts to overheat. This situation forces the central bank to intervene to avoid hyperinflation. To do this, the central bank adopts contractionary monetary policies. One option is to raise the central bank lending rate, sell government securities through open market operations, and increase the reserve requirement ratio.
An increase in the interest rate slows inflation through its effect on various channels of monetary policy transmission. It leads to higher borrowing costs, lowering asset prices, weakening business expectations, and exchange rate appreciation. All those lead to a decrease in aggregate demand, thereby moderating inflation and reducing short-run aggregate output.
Take the case of borrowing costs. The central bank can influence the availability and cost of credit through its lending rates and money market operations. When the central bank announces an increase in lending rates, commercial banks will usually follow. They will raise the base rates on loans to debtors. The higher the central bank’s lending rates, the more likely the bank is to reduce lending and thereby reduce the money supply.
An increase in interest rates reduces the demand for new loans. Because it is more expensive, households reduce consumption of goods that have been financed by loans, such as cars or homes. Likewise, businesses reduce the purchase of capital assets because higher costs make such investments less profitable.
Reduction in household consumption and business investment reduces aggregate demand. Businesses see the outlook for demand and profits weakening, encouraging them to cut output. As a result, falling aggregate demand moderates inflation and economic growth. However, it can also increase unemployment.
Lowering the central bank lending rate
The central bank reduces interest rates to stimulate economic growth. Lower borrowing costs encourage private spending and investment. The decline ultimately leads to an increase in aggregate demand and stimulates economic growth.
A decrease in interest rates affects the economy through the monetary policy transmission channel, which is the same as an increase in interest rates. It’s just the opposite effect.
Take the case of household consumption and business investment. When interest rates fall, borrowing costs are cheaper. Households are eager to apply for new loans to buy some items, especially durable goods such as cars. Likewise, businesses begin ordering capital equipment, such as light equipment.
Both increases improve the outlook for aggregate demand in the economy. Companies then start to increase their output and start recruiting new workers. Strengthening aggregate demand will further stimulate economic growth, reduce unemployment, and create upward pressure on the prices of goods and services (inflation).
Monetary transmission: How central bank lending rate impact the economy
The central bank lending rate might seem like a single lever, but its influence on the economy is a multi-stage process called monetary policy transmission. This intricate web of interactions translates adjustments in the central bank rate into tangible effects on borrowing costs, spending, and economic activity. Here’s a breakdown of the key channels:
Bank lending channel
This is the most direct channel. When the central bank lowers its rate, commercial banks typically follow suit by reducing their own interest rates on loans. This incentivizes businesses and consumers to borrow more, injecting money into the economy and boosting aggregate demand.
Businesses can invest in expanding operations or purchase new equipment, while consumers might be more inclined to take out loans for cars, homes, or renovations. This increased borrowing and spending ultimately leads to higher production and economic growth.
Asset price channel
Lower interest rates can also trigger a rise in asset prices, such as stocks and real estate. This “wealth effect” makes people feel more confident about their financial situation, encouraging them to spend more.
Imagine seeing the value of your stock portfolio increase—you might feel more comfortable splurging on a vacation or a new appliance. Additionally, rising asset prices can make it easier for businesses to obtain loans by using their assets as collateral, further greasing the wheels of economic activity.
Exchange rate channel
A central bank lowering its rates can weaken the domestic currency relative to foreign currencies. This makes exports cheaper and imports more expensive. Cheaper exports become more attractive to foreign buyers, potentially increasing production and creating jobs in export-oriented industries.
Conversely, imports become relatively more expensive, encouraging consumers to turn towards domestically produced goods. This shift in consumer behavior can stimulate domestic production and economic activity.
Inflation expectations channel
The central bank’s actions also influence expectations about future inflation. If the central bank consistently lowers rates to stimulate growth, businesses and consumers might start to anticipate rising prices.
Businesses might pre-emptively raise wages to keep up with expected inflation, and consumers might rush to purchase goods before prices go up further. This can lead to a self-fulfilling prophecy, where both wage demands and price increases actually materialize, fueling inflation itself. To prevent this, the central bank must carefully calibrate its rate adjustments, considering not only growth but also potential inflationary pressures.
