What is monetary policy and its relationship to interest rates?
Central banks use monetary policy to combat economic fluctuations and achieve price stability, which means low and stable inflation. Central banks in many advanced economies set explicit inflation targets. Now, many developing countries are also turning to an inflation targeting framework.
Central banks conduct monetary policy by adjusting the money supply, usually by buying or selling securities on the open market. Open market operations affect short-term interest rates, which in turn affect longer-term rates and economic activity. In addition to the most important tool that the central bank uses to control inflation and determine its monetary policy, it is interest rates. In short, when central banks reduce interest rates, monetary policy becomes accommodative. When interest rates are raised, monetary policy is tight.
The concept of interest rate and its importance?
The interest rate is a key tool for central banks to adjust a country's monetary policy, meaning it determines the "price of money." Interest is an insurance that money will not be returned if a person or company borrows it, and this insurance is determined by the interest rate.
Central banks set the base interest rate, which is the cost of interbank borrowing, and banks and financial institutions set an interest rate on loans and savings based on this base interest rate.
The central bank raises interest when the rate of inflation in the economy increases (an increase in the prices of goods and services), and thus makes the price of money expensive, so borrowing for people and businesses decreases, and spending and demand for consumption decrease, so inflation decreases.
The central bank reduces interest in the event of an economic recession, making the price of money cheap, increasing borrowing and thus consumer spending, and the economy revives, thus emerging from the recession.
Of course, things do not always go "by book", but that is the conventional economic wisdom, and although there are other factors that the monetary authorities take into account when setting the interest rate, the most important is the inflation or recession index.
The impact of interest rates on the economy as a whole and individuals ?
The impact of the change in interest rates does not appear immediately, but rather it takes about a year and its impact may begin to appear on the economy and individuals.
When interest rates rise, borrowing becomes expensive, businesses reduce their investments and individuals reduce their consumption spending.
For example, a car or home loan becomes more expensive in installments, making the individual hesitant to buy, and financing projects becomes more expensive, so jobs reduce wages and jobs.
The opposite is true when interest rates are lowered, but cheap money for a long period may lead to a bubble in the economy. The more it inflates, the more painful its collapse will be.
Raising or lowering the interest rate is inversely proportional to the price of bonds (issued by companies and countries to borrow from money markets).
One of the indirect effects is that raising interest leads to an increase in the exchange rate of the currency in question, which affects the direction of investors away from stock and commodity markets to currency markets, and vice versa is also true.
