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Why Do Central Banks Raise Interest Rates?

When the Central bank (In terms of India it is Reserve Bank of India, in the USA it is Federal Reserve System) raises interest rates, It is a piece of big news. It can send waves across the whole economy. Increasing interest rate is the primary tool used by the central bank to manage inflation in the economy. Today through this article, we will understand why the central bank raises or cut down the interest rate in a simple manner.

What is the Interest rate?

If you take loan, you will have to pay a little extra to the lender to make it adequate for the lender. This is called interest rate. The Interest rate is charged by the lender on the loan amount. The interest rate is the amount charged on the principal amount to a borrower by a lender for the use of the asset.

What is Inflation?

Inflation is the augmentation in the price of goods or services. It results decrease in the value of money. Let’s understand with a simple example:-  Let’s say if you purchase 1 kg of Mango for INR 100 in year 1, if inflation hit the economy by say 8% per annum then the price of the same 1 kg Mango will be INR 108 (simply 100+8 (8% of INR 100) in second year. It means that you are not able to purchase 1 kg Mango by paying the same amount INR 100. Likewise in an economy, prices of all the essential goods and/or services increase because of inflation. These can impact on the economy in long term.

How interest rate helps in controlling inflation? When central banks increase the interest rate, they are trying to control inflation.

Now let us see how the interest rate helps in controlling excess inflation in the economy?

When the central bank change their interest rates, the change spreads through the financial system and slows down the inflation rate. Here’s how:-

  • Hike in the interest rates from a central bank means that the commercial bank will earn more on their reserves. They can make more from keeping their money in a central bank than lending it out. Thus if they do lend it out, they will raise their interest rates to make it worth their while. It affects consumers spending sentiment. More interest rates mean higher borrowing costs. Higher loan costs left less in the hand of consumers which is decreasing their purchasing power, hence they spend less. When they spend less, business firms try to avoid increasing the prices of their goods or services and that is how it leads to slowing the inflation which is the primary goal of central banks in raising interest rates.
  • On the other side, if the interest rate rises, customers earn more on their savings. It encourages people to save money and spend less. It again leads to slow inflation because of the “spend less save more” behaviour of consumers.
  • It is not only customers who will stifle their purses, but the business house also. When there is rise in interest rate the business will find it more expensive to borrow and invest the money, it means less economic activity. It means fewer jobs are created. Fewer Jobs & less wages could mean less money for households and consumer confidence might suffer, it also means less expenses. Lower expense will translate into lower inflation.
  • In India, the most famous interest rate is Repo Rate (RR) and Reverse Repo Rate (RRR) The Repo rate is the fixed interest rate at which the RBI provides overnight liquidity to banks against the approved securities and collateral of Government. Repo (Repurchase Option). On the contrary, the Reverse Repo rate is the interest rate at which RBI absorbs liquidity on an overnight basis, from banks against collateral of eligible government securities.
  • In India, there are many interest rates and are mainly dependent on the repo rate as decided by the Reserve Bank of India. When Reserve Bank of India increases the repo rate, it means that banks will borrow less from RBI. It means in economy liquidity will be low, with less money supply and leading to lower inflation. If banks borrow money from Reserve Bank of India to lend it further to the borrower, they will have to decide their lending rate based on the RR which obviously will be high due to the higher repo rate.