Central Banks Targets

A central bank is a national institution granted the prerogative to control the printing and supply of money and credit. Central banks play important roles in the economy since they are the sole suppliers of currency to the government, bankers to commercial banks, lenders of last resort, supervisers of the payment systems, and implementers of the monetary policy.

Interest Rates Targeting

A central bank has a policy rate that is the most evident expression of its aims and opinion. The policy rate is expressed through interest rates. The rate that the central bank declares publicly is the rate at which it is able to loan money to commercial banks. This policy is achieved by using short-term collateralized rates.

The policy enables the central bank to manage the sum of money in the money markets. So, the higher the interest rates, the higher the penalty that commercial banks will have to pay the central bank if they run short of liquidity. This reduces the capacity of commercial banks to lend money to the public and, hence, causes a reduction in money supply.

Inflation Rate Targeting

Occasionally, the central bank receives a degree of freedom to act on its own without the permission of the government during an inflationary period. This freedom is crucial, for example, in regulating politicians’ decisions to set an inflation target and authorize the central bank to set interest rates as ordered.

This inflationary target could be a benchmark. When this is the case, other policies are implemented to ensure that the inflation rate within the economy does not grow beyond the targeted inflation rate within a given period of time.

Another degree of independence is target independence. This is not only intended to control lending rates but also the rate of inflation they target.

Exchange Rate Targeting

The exchange rate is directly connected to the stability of an economy. The central bank, therefore, keenly monitors the forex market and takes necessary measures whenever there is need. This has the aim of protecting the foreign interest of the country within its jurisdiction.

In this regard, the central bank plays a crucial role in altering interest rates. An increase in interest rates stimulates traders to buy the respective country’s currency. This results in a stronger currency compared to other countries.

Question

A central bank increases its policy rate. How will this reduce the inflationary pressures?

A. By reducing the consumer demand

B. By raising asset prices which will lead to an increase in household wealth

C. By reducing the foreign exchange value of the currency

Solution

The correct answer is A.

A successful increase in policy rates will decrease consumer demand due to rise in credit rates. This decline in demand, therefore, results in a reduction of pressure on consumer prices.

Option B is incorrect. Increasing the policy rate will reduce asset prices because banks will be reluctant to loan to businesses and consumers. As such, there will be less investment and consumption.

Option C is incorrect. Increasing the interest rate will increase the domestic country’s currency. This will result in a stronger currency compared to other countries, decreasing imports.

Reading 16 LOS 16l:

Contrast the use of inflation, interest rate, and exchange rate targeting by central banks.