Ways a Central Bank Control the Level of Short-Term Interest Rates
Interest rates are the equilibrium price in a financial market through which borrowing and lending of money occur. A country’s central bank is responsible for implementing the state’s monetary policy. The monetary policy provides the central bank with the necessary tool to manipulate the interest rates. The integrity of a financial system is determined by the rates of interests being paid or charged, as the higher the interest rate, the greater is the risk of investment. The interest rate determines the reward investors and savers obtain for authentic goods and services. Interest rates can be classified as either nominal rates or natural interest rates. A nominal rate is a rate charged on a savings account. The actual interest rate is determined by the difference between the current inflation rate and the nominal rate. If the inflation rate is lower than the nominal rate, savers gain value. A higher rate of inflation results in the real interest rate being negative. Therefore, the interest rate paid or charged on savings is subject to the rate of inflation at any particular time.
On the other hand, borrowers are always charged higher interest on their loans than on savings. Consequently, the inflation rate is lower than the nominal interest as far as borrowing is concerned. The interest rate determines the price for money during financial transactions. Lenders are compensated for the loss of liquidity based on the interest rate, the inflation rate, and the potential risk that the lender’s money will not be paid. Therefore, the interest rate is the main component of a government’s monetary policy. The value of the interest rate in a free market is determined by the supply and demand for loans. The collection is proportional to the number of entities willing to lend, while the proportion of potential borrowers determines the order.
Generally speaking, people’s expenditure is based on their incomes and borrowed money. A lower interest rate causes the economy to grow, reduces the rate of unemployment, and increases people’s expenditure and demand for loans. High cost increases the inflation rate because there is increased demand for goods and services whose supply is limited. A government keen on regulating interest rates at a minimum focuses on reducing expenditure by making credit more expensive through a proportionate increase of interest rates. Therefore, the central bank adjusts market conditions such that short-term interest rates are imposed on the monetary system. Therefore, people’s financial decisions are a response to the prevailing rate of inflation and the associated pattern of interest rates. If an increase in inflation is expected to raise interest rates, then people are expected not to demand higher salaries or otherwise conform to price stability as a compensatory measure.
The repo and interbank markets enable financial institutions to adjust their liquidity positions accordingly. The overall financial parts of banks keep shifting from that of a general surplus to one of an overall deficit. Interest rates in financial markets determine the nature of risk in whatever transactions between lenders and borrowers. To finance its budgetary deficit, the government floats hilt-edged securities in the stock market. The fiscal deficit could arise from insufficient tax revenue prompting the government to borrow from financial institutions and private investors, among others, to meet its budgetary obligations. Since the government is the borrower, gilt securities are much more secure than personal claims. Financial institutions with a cash surplus lend the government through the gilded as collateral. The central bank uses gilt-edged guards to restore liquidity in the financial markets in case of a shortage that could arise from huge tax payments by the private sector and in situations where commercial banks buy banknotes from the central bank.
The central therefore manages the financial system so that a financial deficit exists, which must be covered through borrowing from its reserves. Thus, the central bank lends institutions cash in exchange for the gilt securities that are redeemable short-term maturities ranging from overnight to a few months. The central bank determines a marginal cost for the loan as the interest rate charged on the repo. The repo rate filters through the entire financial system and impacts both short-term and long-term interest rates. Banks also use the repo market in adjusting their liquidity positions appropriately. Financial institutions with a surplus lend those having a shortage through the redeemable secured gilt-edged securities. The central bank uses the repo market to refinance the financial system in the short term. Gilts are safe claims on the state which can be used as collateral in the interbank market at the same interest rate used in the repo market. It facilitates borrowing, especially by financial institutions with a lower credit rating.
On the other hand, the interbank market allows for lending and borrowing between banks. Still, the interest rate charged on the loans is higher, making it expensive, especially to institutions with lower credit ratings. The central bank also raises funds for the government by issuing treasury bills that are equally redeemable within short-term periods. The treasury bills do not earn interest but are issued at a discount to the face value. The treasury bills are repaid higher than the issuing p on redemption date rice. The central bank, therefore, ensures that the money supply in the economy is enough for desired transactions to take place while it regulates the supply of money to control the rate of inflation. Therefore, open market operations are:
- A combination of short-term repos by the central bank.
- Long-term repos in the interbank market.
- The issuance of high-quality bonds.
Banks adjust their lending rates and interests accruing to deposits based on the interest rates in the repo and interbank markets.