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Questionsaboutstuff's avatar

What does it mean when a central bank increases interest rates?

Asked by Questionsaboutstuff (265points) August 7th, 2014

Do banks borrow from the central bank and have they pay the central bank?
Why would a central bank want to increase interest rates ?

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6 Answers

Lightlyseared's avatar

It’s usually the interest rate that banks can borrow from each other and yes they have to pay back any money they borrow. Comercial banks will also use the central banks interest rate to base their own interest rates on – for example its quite common to see a mortgage advertised as 2% (or whatever) above the central banks interest rate. When the central bank increases interest rates it means it will cost more to borrow money but savers (particularly pensions) will see a bigger return on savings. It will for example increase the cost of a mortgage on a house and low interest rates tend to encourage investment in property possibly borrowing more money than they can afford to repay if their financial situation changes even slightly. This is probably the main cause of the financial crisis in 2007. By gradually increasing the interest rate the central bank tries to reduce the amount of borrowing and therefore the potential exposure to loses of banks.

Questionsaboutstuff's avatar

So if I’m bank X and I want some more money the amount I can borrow from bank Y is set by the government?

Why do banks feel the need to change their interest rates based on the central bank? More expensive for them to operate?

LuckyGuy's avatar

The central bank can adjust the economy to either stimulate it when it is too slow or cool it off if it is running away due to inflation. If they raise the interest rate money managers will put money in banks, bonds and move it from riskier investments like the market. If they lower interest rates money manager move money into other higher yield investments like stocks giving dividends above bank rates. If money is cheap to borrow businesses will tend to invest in capital equipment and grow their business. If money is expensive to borrow they will be reluctant to borrow and will instead hunker down and stick cash in the bank.

It is one of the knobs the Fed has to tune the economy.

zenvelo's avatar

Central Banks lend funds overnight to banks in need of cash, often to make sure they have enough reserves on hand. That’s the Fed Discount Window, and the rate charged is called the Discount Rate. There is also the Fed Funds Rate which is the rate set bet the Fed for interbank uncollateralized lending of funds on deposit at the Fed.

Banks can lend money outside the Fed System but the accounting and reserve requirements for that lending are different than if they are on deposit at the Fed and lent at the Fed Funds Rate. The Fed Funds Rate is usually the lowest available rate at any given time.

Imadethisupwithnoforethought's avatar

It means in practice that a central bank is worried that inflation is rising too fast. Prices are rising and it may be due to too much money sloshing around the economy. Borrowed money (a bank goes to a central bank and borrows money, which is then loaned out) is just like printing money. When you borrow on a credit card, you print money, just like the US treasury.

If you increase interest rates, it makes it more expensive to borrow from the government for banks. They then raise interest rates on their customers and credit card companies. Everybody thinks a little more before they borrow.

Ideally, this makes people think a little harder before they buy stuff, and purchase things that are priced fairly. So you stop crazy inflation before it gets going.

SQUEEKY2's avatar

What the others have said is very true, but in great simpler terms the banks get mad at seeing business screw the working joe, so they do it so they can get their chance to screw the working man as well.
But they claim it’s for the good of the economy, boy they sure are the good guys huh? NOT!!

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