The Central Bank and Interest Rates

Episode #8 of the course Fundamentals of economics by Dr. Michael McDonald

In past lessons, we looked at two principle goals of governments around the world: promoting economic growth and limiting unemployment. This lesson and the next, we will look at the tools governments use to try and achieve those objectives.

Perhaps the most important modern economic tool for governments is monetary policy. It involves controlling and manipulating the money supply to try and achieve specific objectives. This practice is generally carried out by the Central Bank of a country. For example, in the US, the Central Bank is called the Federal Reserve, while in European Union, it is the European Central Bank, or ECB.

How Central Banks Influence the Economy

Central Banks around the world vary slightly, but most are similar to the US Federal Reserve, which we will be using as an example in this lesson.

The Federal Reserve, or Fed, is tasked with two primary mandates:

• maintaining a low level of unemployment

• keeping inflation at a target level (we’ll talk about the problem of inflation in Lesson 10)

Each goal requires steering the economy so it is growing but not growing so quickly that problems result.

As the Federal Reserve is the regulator for the banking system, it controls the money supply in the US economy. All banks have to report to the Fed, and they can turn to the Fed if they are in trouble and need additional money to avoid failing.

Controlling the money supply is extremely important because it also means that the Fed controls interest rates (the rate that banks charge customers who borrow money from them) in the economy. This is the Fed’s primary lever to boost the economy when it is growing too slowly, or slow the economy when it is growing too fast.

Specifically, because the Fed can set its discount rate (the rate it charges banks that borrow money from it) and it controls the banking system, when the Fed raises or lowers interest rates, all banks across the country follow. Higher interest rates from banks on loans to average people for houses, cars, and other major purchases lead to fewer buyers of these products. That, in turn, slows the economy. Similarly, when interest rates fall, people are better able to afford to splurge on a fancy car or a bigger house, which in turn helps boost the economy.

The interest rate level is the key tool for the Fed.

Tools of the Fed to Adjust Interest Rates

The Fed Controls the money supply and interest rates in the economy through three primary processes.

1. Changing the discount rate. The Fed is the bank for banks. When banks need to borrow money to lend to customers, they turn to the Fed. If the Fed raises the rate that they charge to banks, the banks have to charge higher interest rates to their customers as well.

2. Buying and selling Treasury bonds. The Fed is a major holder of US government bonds (bonds are debt securities issued by companies or governments to fund major capital projects—similar to a person getting a bank loan). When the Fed wants to increase the money supply, it prints new money (or these days, creates the money electronically) and then buys treasury bonds from banks across the economy. This puts more money into the vaults of banks and encourages them to make more loans at lower interest rates. Similarly, the Fed can reduce the money supply and raise rates by selling Treasury bonds it already holds to banks in exchange for some of the cash in the bank’s vault.

3. Changing the reserve requirement. The Fed is the primary backstop for banks across the country, and as a result, the government gives the Fed the authority to tell individual local banks how much cash they have to hold relative to the loans they have made. This is called the “reserve requirement,” If the Fed raises the reserve requirement, it reduces the amount of money banks can loan to consumers. While the US Fed rarely relies on this tool, it is more commonly used in some other countries. The Chinese Central Bank has been notably active in controlling its money supply through the reserve requirement, for instance.

Next time, we’ll look at the second major mechanism for the government to control the economy: fiscal policy.

Recommended book

Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics by Henry Hazlitt