Central banks influence interest rates through monetary policy from "summary" of Financial Markets and Institutions, Global Edition by Frederic S. Mishkin,Stanley G. Eakins
Central banks play a crucial role in influencing interest rates through their monetary policy decisions. Monetary policy refers to the actions taken by a central bank to control the money supply and achieve macroeconomic objectives such as price stability and full employment. One of the primary tools used by central banks to influence interest rates is open market operations. In open market operations, the central bank buys or sells government securities in the open market to adjust the level of reserves in the banking system. By buying government securities, the central bank injects reserves into the banking system, leading to an increase in the supply of money and a decrease in short-term interest rates. Conversely, when the central bank sells government securities, it absorbs reserves from the banking system, reducing the money supply and causing short-term interest rates to rise.
Another tool used by central banks to influence interest rates is the discount rate. The discount rate is the interest rate at which commercial banks can borrow reserves directly from the central bank. By changing the discount rate, the central bank can encourage or discourage banks from borrowing reserves, thereby affecting the level of reserves in the banking system and influencing interest rates. A reduction in the discount rate makes it cheaper for banks to borrow reserves, leading to an increase in the money supply and a decrease in short-term interest rates. On the other hand, an increase in the discount rate makes it more expensive for banks to borrow reserves, resulting in a decrease in the money supply and an increase in short-term interest rates.
In addition to open market operations and the discount rate, central banks can also influence interest rates through forward guidance and quantitative easing. Forward guidance involves providing information to the public about the future path of monetary policy, which can help shape expectations about future interest rates and influence current interest rates. Quantitative easing is a policy in which the central bank purchases long-term securities to lower long-term interest rates and stimulate economic activity. By using these various tools of monetary policy, central banks can effectively influence interest rates to achieve their macroeconomic objectives and maintain economic stability.
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