The central bank lending rate is the interest rate at which banks borrow directly from the central bank. The central bank uses it to influence short-term interest rates and to affect long-term interest rates in the economy indirectly.
Changes in interest rates can affect economic activity through its effect on aggregate demand. These changes ultimately affect inflation and economic growth.
When the central bank wants to stimulate economic growth, it may reduce interest rates on its loans. When the central bank intends to moderate economic growth and inflation, it can raise its lending rate.
How the central bank lending rate works
An interest rate represents the cost of borrowing money and describe what creditors get when lending money. A higher interest rate means the cost of borrowing money is more expensive, and conversely, a lower interest rate means the cost of borrowing money is cheaper.
The central bank changes its lending rates to ensure the stability of economic activity. Fluctuations in the business cycle sometimes produce adverse consequences such as hyperinflation or recession. To avoid that, the central bank tries to intervene in the economy through lending rates, as well as through other monetary policy tools such as open market operations and reserve requirement ratios.
When the central bank raises interest rates
When inflationary pressures are too high, the economy starts to overheat. The situation forces the central bank to intervene in the economy to avoid hyperinflation. To do this, the central bank adopts contractionary monetary policies. One option is to raise the central bank lending rate, as well as to sell government securities through open market operations and to increase the reserve requirement ratio.
An increase in the interest rate slows inflation through its effect on various channels of monetary policy transmission. An increase in interest rates 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.
When the central bank cuts its 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 from 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).