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Author Topic: How does a central bank actually implement a change of IR throughout the economy  (Read 396 times)
mcplums
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November 03, 2015, 12:39:19 PM
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In other words, what are the intermediate stages between the central bank agreeing to increase interest rates and my mortgage going up?

I've always wanted to know.

Thanks chaps.
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odolvlobo
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November 04, 2015, 01:28:39 AM
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Banks must maintain a certain balance (their "reserve") at the central bank. In order for a bank to prevent their reserve from going below the limit, they borrow the money from banks with excess reserves. By competing with banks for those excess reserves, the central bank can influence the interest rate that a bank must pay another bank. A bank will then lend to customers at a higher interest rate in order to make a profit.

In short, one way the central bank controls interest rates is by indirectly controlling the interest rate of money available to banks for lending.

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November 04, 2015, 05:52:24 AM
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Banks must maintain a certain balance (their "reserve") at the central bank. In order for a bank to prevent their reserve from going below the limit, they borrow the money from banks with excess reserves. By competing with banks for those excess reserves, the central bank can influence the interest rate that a bank must pay another bank. A bank will then lend to customers at a higher interest rate in order to make a profit.

In short, one way the central bank controls interest rates is by indirectly controlling the interest rate of money available to banks for lending.

Great explanation! It's all about loans and cost of borrowing money drives everything else. Crazy, huh?

mcplums
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November 05, 2015, 02:59:09 PM
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Banks must maintain a certain balance (their "reserve") at the central bank. In order for a bank to prevent their reserve from going below the limit, they borrow the money from banks with excess reserves. By competing with banks for those excess reserves, the central bank can influence the interest rate that a bank must pay another bank. A bank will then lend to customers at a higher interest rate in order to make a profit.

In short, one way the central bank controls interest rates is by indirectly controlling the interest rate of money available to banks for lending.

Is this what 'open market operations' is all about?
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November 05, 2015, 03:12:14 PM
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There is an article on the link below that you might find interesting to read as it explains interest rates in quite some detail.

Its mainly applicable to the US but the same principle applies in most countries.

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Interest rates are one of the Fed's most powerful tools for implementing monetary policy. The Fed sets several key interest rates that influence borrowing and lending across the economic spectrum. The first is the federal funds rate, which is the interest rate that one bank charges to another for borrowing cash reserves. It's calculated according to basic laws of supply and demand. The more money banks have in reserves, the lower the rate. The more demand for loans, the higher the rate.

The interesting part is that the Fed controls the supply and demand. If the Fed wants to lower the funds rate, it buys securities from banks, injecting more cash into their reserves. If the Fed wants to raise the funds rate, it sells government securities back to the banks, lowering their cash reserves. This tinkering with supply and demand is called open market operations, another tool of monetary policy.

http://money.howstuffworks.com/interest-rate.htm
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