A country’s central bank sets the interest rate at which commercial banks obtain liquidity. This interest rate, known as the key interest rate, determines the conditions under which the banks can borrow money from the central bank.
- The key interest rate influences the level of loan and savings interest.
- In the euro area, the European Central Bank sets the key interest rate.
- Low key interest rates should stimulate the economy.
Key interest rate: an instrument for money market management
Key interest rates have a significant impact on the situation on the money market, which makes them key instruments of monetary policy. Because through the commercial banks, the key interest rate also has an indirect effect on everyday life. For example, the amount of the interest income on savings deposits as well as the interest rate on loans depend on it . As a result, changes in key interest rates have an impact on the costs of investments and loans. The consequences affect economic growth, consumer confidence and the unemployment rate
The central banks control the key interest rate
The state is interested in keeping the price level and the value of money in a currency area stable and responsive to events like one To be able to react to inflation . The central bank, also known as the central bank, fulfills this purpose. In Germany the pursued Deutsche Bundesbank until 1998 this goal. Since then, the European Central Bank (ECB) has taken on the task of ensuring price stability in the euro area. The discount rate valid until 1998 – the interest rate at which the Bundesbank bought the euro from commercial banks – has been replaced by the base rate. Examples of banks in national currency areas are the US Federal Reserve System (FED), the Bank of England and the Swiss National Bank.
Effects of the base rate
By changing the key interest rate, the central bank influences the money supply and economic development in the entire currency area. If the key interest rate rises, capital market rates rise. This is to fight inflation. A cut in key rates is supposed to help a weak recovery lead the economy . The corrections in the key interest rate also have an effect on the strength of one’s own currency compared to foreign currencies. The rate cut is also depressing the price of its own currency – and vice versa. This is how central banks control imports and exports.
That means a high key interest rate
An increase in the interest rate which is short for IR by abbreviationfinder, increases the price of money, which ultimately leads to a shortage of money. For commercial banks that is borrowing money has become more expensive and they pass this cost increase on to consumers. For them, too, borrowing becomes more expensive. The incentives in the private sector to take out loans are decreasing. On the other hand, interest-bearing investments become more lucrative. From a macroeconomic perspective, the key interest rate cut is cooling the economy and lowering the inflation rate. The savings rate rises, the investment rate falls.
That means a lower key interest rate
The lowering of the key interest rate has the opposite effects in terms of model theory. Loans are becoming cheaper, which has an impact on willingness to consume and invest. As a result, the investment rate rises, but the savings rate falls. The growing demand for money promotes economic growth and enlivens the stock market. However, the risk of an increased inflation rate increases.
Influence of the key interest rate on private investors
The central bank’s interest rate decisions are therefore quickly felt by private consumers as well. The rise in the key interest rate drives up interest rates for fixed-term deposits and call money accounts . A reduction makes loans cheaper, but the interest on investments melts. Persistently low key interest rates in particular mean difficult times for savers. With classic savings accounts can no longer increase money in the long term and should reorientate themselves towards alternative investments such as stocks or funds. Fixed-term deposits and overnight deposits are still options for short-term investments, for example when saving for a larger expense. Here the saver can also react quickly to changes in interest rates.
Criticism of the key rate
The theoretical model function of the key interest rate is not always reflected in economic reality. Since the economic crisis of 2008, a relative decoupling of the key rate and the interest rates charged by commercial banks has been observed. The key interest rate, which has been severely reduced since the crisis, had not led to the corresponding behavior in lending rates. Some experts consider the reserve requirement and money creation to be more important in lending. In addition, the supply / demand factor must not be underestimated.