A central bank is a national institution granted prerogative to control the printing and supplying of money and credit. Central banks play an important role in the economy as they are the sole suppliers of currency to the government, a banker to commercial banks, act as lenders of last resort, supervise the payment systems, and conduct the monetary policy.
A central bank has a policy rate that is the most evident expression of its aims and opinion which is expressed through interest rates. The rate that the bank declares publicly is the rate at which it is able to loan money to the 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 the commercial banks will have to pay the central bank if they run short of liquidity. This reduces the chances of banks lending money to the public and, hence, causes a reduction in the money supply.
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, so as to control 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, and when this is done, other policies are implemented to ensure that inflation rate within the economy does not grow beyond the targeted inflation rate within a given period of time.
Another degree of independence is the target independence. This is not only intended to control lending rates but also the rate of inflation they target.
The exchange rate is directly connected with the stability of an economy so the central bank keenly monitors the forex market and takes necessary measures if need be. This as an aim of protecting the foreign interest of the country it represents.
In this regard, the central bank plays a crucial role in altering the 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.
If a central bank’s policy rate increases, how will it be expected to reduce the inflationary pressures?
A. By reducing the consumer demand
B. By raising asset prices which will lead to an increase in households wealth
C. By reducing the foreign exchange value of the currency
The correct answer is A.
A successful increase in policy rates will decrease its consumer demand since credit rates have risen. The decline in demand, therefore, results in a reduced pressure on consumer prices.
Reading 18 LOS 18l:
Contrast the use of inflation, interest rate, and exchange rate targeting by central banks.