The policy rate is the interest rate used by the central bank as an instrument of monetary policy. It is usually the rate at which the central bank is willing to lend money to commercial banks. Through it, the central bank influences short-term interest rates and the money supply in the economy.
The policy rate is a key and another alternative of monetary policy tools such as reserve requirements and open market operations.
The difference between policy rate and bank’s lending rate
The policy rate is similar to bank’ lending rates. Both reflect the level of costs of borrowing money.
The difference of both is on who is the debtor. In bank’s lending rates, banks act as creditors, and their debtors can be individuals, non-bank corporations, or other banks. Whereas for policy rates, the central bank acts as the creditor, and the commercial bank is the debtor. The central bank charges an interest rate (known as the discount rate) for short-term loans, usually overnight loans.
How do interest rates affect monetary policy?
The effect of interest rate changes on the economy can take a variety of channels. It is not only through changes in consumption and investment but also through asset prices, economic agent expectations, and exchange rates. Each of these channels influences aggregate demand in the economy and impacts on economic growth, inflation, and unemployment. However, to summarize, we only discuss transmission through changes in consumption and investment.
The central bank lowers policy rates to stimulate economic growth. This policy is called the expansionary monetary policy. The central this policy during weak economic growth and aims to avoid a recession.
The central bank expects that commercial banks will follow the decline by lowering their lending rates. When interest rates fall, borrowing costs are cheaper, encouraging households and businesses to borrow more money and increase spending and investment in goods and services (aggregate demand increases).
Increased demand for goods and services stimulates producers to increase production. When demand strengthens, businesses start recruiting workers and raising selling prices to compensate for rising production costs. As a result, economic activity grows, unemployment falls, and inflation begins to move up.
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Conversely, the central bank will raise the policy rate to avoid the overheated economy and prevent hyperinflation. We call this policy rate increase as a contractionary monetary policy.
The purpose of contractionary monetary policy is to reduce high inflationary pressures. Higher policy rates make loans more expensive. The higher the policy level, the higher the penalty that banks must pay to the central bank if they lack liquidity. This situation will make them more conservative in making loans, reducing the money supply.
Because loans to central banks are more expensive, commercial banks then raise the interest rates they charge to debtors. An increase in bank interest rates weakens the demand of households and businesses for goods and services, especially those financed by loans. Weakening aggregate demand forces producers to cut output and reduce their labor. As a result, economic growth contracts, inflation becomes more moderate, and unemployment rises.
