Central Bank Interest Rates are the rates at which the central bank lends to other commercial banks and non-banking funds or institutions. This interest rate is often called the Repo Rate, short for Repurchase Rate.
Understanding Central Bank Interest Rates
Central Bank interest rates play a key role in an economy. They control the amount of money circulating in an economy, control inflation, and provide support to the markets via liquidity infusion during a recession.
Understanding Repo and Reverse Repo Rates
A central bank performs multiple functions in an economy; one of these is to act as a banker to banks. If a bank has excess money, the central bank accepts that money and provides an interest on it (called the reverse repo rate).
Similarly, if a bank requires additional capital, the central bank lends it this capital at a rate called the repo rate. This repo rate is widely known as the Central Bank Interest Rate.
Where do Central Banks Get Money From?
The money deposited by commercial banks with the central bank comes from the general public, such as individuals, businesses, fund houses, and even government bodies.
Similarly, the money lent by the central government to commercial banks enters the economy through the same individuals, businesses, fund houses, and government bodies.
How do Central Banks Influence Commercial Banks to Control Money Supply?
Therefore, a central bank can control the amount of money in an economy by accepting more deposits from commercial banks (which reduces the money supply) or by lending more money to commercial banks (which increases the money supply).
Now, you can understand that reducing money in an economy requires influencing banks to deposit money with it. This is done by raising interest rates. By raising rates, banks can simply deposit their funds with a central bank and enjoy a risk-free return. The risk is zero because returns are guaranteed by the country’s government.
Similarly, to increase the money supply in an economy, the central bank simply has to reduce the interest rates. As a result, commercial banks will profit better by disbursing loans to their customers rather than keeping the funds with the central bank. As a result, more loans are distributed, and more money is injected into the economy.
How do Interest Rates control an Economy?
We have understood the concept of interest rates from the central bank’s perspective. Now, let us see what that money does inside an economy and how central banks handle the imbalance caused by it.
Inflation
Inflation is the scenario when the prices of goods and services rise compared to the previous year. This price rise is caused by a shortage of goods and services or due to an excess of money. In any case, it is described as too much money trying to buy too few items.
To control inflation, a central bank raises interest rates, which leads to two things. First, it attracts commercial banks and people to deposit their funds to earn higher rates, which decreases the money supply in an economy. Second, it raises the interest on loans, which means more payments have to be made on an outstanding loan (car loan, home loan, personal loan, or credit cards). Here, too, the excess money is taken out of the economy, thereby balancing demand and supply.
Recession
A recession happens when the economic growth stalls for any reason. This is a situation that is the reverse of inflation. Here, the goods and services are present, but there is less demand.
An example of this was COVID-19, when lockdowns and supply chain disruptions led to zero economic growth.
To address a recession, a central bank lowers interest rates, thereby injecting money into the economy through commercial banks and the public. Loans and credit are made cheaper, which influences people to buy more goods for consumption and allows businesses to take loans to expand themselves. More business means more salaries and, therefore, more consumption. This finally drives away the recession.
Stagflation
Stagflation is a unique situation in which an economy experiences stagnation (zero or negative growth) combined with inflation. This situation occurs during a recession when, for any reason, the prices of goods and services rise, such as due to a supply chain disruption.
In such cases, the economy is first allowed to grow by lowering interest rates. This increases the short-term inflation, which is then curbed at a later stage by raising rates when the economic growth returns.
Disclaimer: All information provided on this site is purely educational and should not be considered financial advice under any circumstances. Kindly consult your financial advisor before investing.
