How Central Banks Control Interest Rates

Monetary Policy, Central or Reserve Bank, and Interest rates

First Published: March 16, 2010

In Canada, there is a lot of talk about interest rates right now because of the interest rate going up in June. Currently, the interest rate is set at .25 percent, which means that when banks give out loans, they will give out a loan at an interest rate of Prime plus a certain amount of percent. This means that the prime interest rate is .25 percent, so if the bank does prime plus five percent, the interest rate they set is 5.25 percent.

Obviously, the lower the interest rate from the central bank, the less people pay for their mortgages and other credit items. In June, the Bank of Canada is going to be increasing the interest rate in an effort to slow the growth of the real estate market to prevent a bursting of the housing bubble. When the interest rate goes up, so too will the amount it costs to borrow money. For example, if the interest rate goes to 1.25 percent, then that original bank interest rate example goes from 5.25 percent to 6.25 percent. Now, one percent may not seem like much, but on a $400,000 mortgage, that one percent moves the amount of interest paid for the house from $21,000 to $25,000. That is an increase of $4,000!

How is it those central banks set these interest rates and why do they set interest rates?

Well, when a central bank wants to contract the supply of money, they can increase the interest rate. If an economy is growing too fast and in danger of collapsing, you can stop the high amount of borrowing by just raising the central interest rate of the country.

During a tough economic period, a country will then lower their interest rate in order to encourage people to use credit and buy things. For example, when the recession started in 2008, the Canada lowered its interest rate greatly in order to spur on buying. What happened when this was done is the real estate market exploded because it was cheaper than ever to borrow money for a home. With the housing market now breaking records in late-2009 and early-2010, the rest of the Canadian economy began to come out of recession before the United States was able to.

A central bank controlling interest rates and monetary policy actually goes back to 1694 when the Bank of England took on the responsibility of printing notes and backing the money with gold. This maintained the value of the coinage and print notes. As time went on, it was found that to maintain the gold standard that money was compared against, there was the need to constantly change and influence the interest rate to prevent things from going out of control.

While most people know about interest rates, many do not realize just how important the Central Bank is to their lives and the effect it has on how much they pay for their homes and other credit purchases. Our lives would be very different if not for places like the Bank of Canada and its regulation of the prime interest rate.