I’m not an Economist, can you explain in simple terms, how does a central bank’s decision on interest rates affect me?

The central bank is responsible for the monetary policy of a country.  A central bank’s goal is to maintain stability of a country’s currency and the amount of money supply in circulation.

The central bank controls short term interest rates and are the lender of last resort.  (They are the bank’s banker)

By adjusting interest rates either up or down, the central bank manages a country’s inflation and the country’s currency exchange rates.  Interest rates also control the total amount of money in circulation in a country.  As interest rates go up, there is less money in circulation because corporations/people can’t borrow as much.  As interest rates go down, there is more money in circulation because corporations/people can borrow more.

Setting the interest rate is a fine balancing act indeed.  

Things you may want to know…

If the interest rate is set too low, money becomes cheap. This can over stimulate the economy because both corporations and individuals can borrow more and spend more. When there is too much money in circulation this causes increased demand for goods and services for everything, prices go up.  This is what they call inflation.

If the interest rate is set too high, money becomes expensive.  This slows the economy because both corporations and individuals can borrow less and spend less. When there is too little money in circulation this causes a decreased demand for goods and services, prices may go down, people may lose jobs. This can be referred to as a contraction, slowdown or recession.

Remember…

If the central bank is lowering interest rates, they are trying to stimulate the economy – make corporations/people spend more money.  If the central bank is raising interest rates they are trying to cool the economy – make corporations/people spend less money. If the central bank is leaving interest rates the same, they like the economy just like it is.

Interest rate adjustments take months/years to have an affect on the economy and central bankers can make mistakes by setting the interest rate too high or too low for too long of time period. Consider the economy like a super oil tanker and the central banker tries to change its direction with a little outboard motor called interest rate adjustments.  

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5 Comments (+add yours?)

  1. Trackback: Interest Rates » I’m not an Economist, can you explain in simple terms, how does a …
  2. coconews
    May 10, 2008 @ 11:43:52

    Yes, you can go into a great amount of detail about everything a central bank does, but I wanted to keep it simple, so ordinary people could read this and understand the basics how central banks and interest rates decisions work in the the economy in general.

    I would not want to be a central banker, would you?

  3. coconews
    May 10, 2008 @ 12:06:02

    In case you are wondering what the very first comment is above mine, this is what they call a pingback. This is someone who has used my article on their website or blog.

  4. coco's husband
    May 11, 2008 @ 06:52:04

    Hello, Larry

    Stick to the thread topic.

  5. Anonymous
    May 11, 2008 @ 08:04:59

    Thank you for explaining this in terms I can understand better. This makes it more clear for me to understand why people are blaming Mr. Greenspan for this mess.

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