How Does Monetary Policy Affect Interest Rates?

How Does Monetary Policy Affect Interest Rates

Monetary policy consists of the decisions and acts of the central bank of a given nation that influences the supply of money as well as the interest rates. It is a tool in the hand of the government to control inflation, reduce liquidity, and grow the economy.

Here, the actions of the government through the central bank are targeted at realizing the macro-economic goals of the government. It is believed that where the supply of money is adequately regulated, it leads to favorable economic impact. This is why it becomes necessary to regulate the circulation of money.

The question is, how does monetary policy affect interest rates?

In answering the question of how monetary policy affects interest rates, it is essential to note that the government may introduce restrictive monetary policy by raising the interest rate on short-term investments when it realizes that the rate of inflation is growing higher. On the other hand, the government may also introduce an accommodative monetary policy that reduces the interest rate on short term investment in ways that boost the economy when it realizes that the economy is not improving at a fast pace.

In essence, we can answer the question; how does monetary policy affect interest rates by saying that the effect of monetary policies on interest rates is both direct and indirect.

How Does Monetary Policy Affect Interest Rates Directly?

It is to be noted that primarily, monetary policy affects the interest rate directly. The various monetary policies adopted by the government determine the interest rate at a particular time.

One of the ways through which the government controls the supply of money in the economy is through the regulation of interest rates on investment, lending, and borrowing. Changes in interest rate do not; however, uniformly affect the economy. The effects of these changes usually differ from one industry to the other. However, some industries are more prone to be affected by these changes than others.

The various media through which monetary policies affect the interest rate are:

The Contractionary Policy:

The contractionary policy is also referred to as the restrictive monetary policy. This is a policy that increases the short-term interest rate to reduce the amount of money in supply. This move by the government has the effect of reducing inflation. Here, the cost of borrowing increases, and there is lesser money in circulation.

The central bank usually gives short-term loans to commercial banks for them to meet up with a short-term shortage of liquidity. When these short-term loans are provided, the central bank charges interest rates on them. It is these interest rates that are increased when the central bank introduces a contractionary policy. Due to the increase, commercial banks will, in turn, charge more interest rates to their customers.

The resultant effect of the contractionary policy is that it reduces inflation and reduces the prices of things within the economy. With this, it causes a higher unemployment rate as the snail pace of economic activity begins to affect companies, and lesser employment opportunities abound. However, it is believed that it is a price that has to be paid to ensure that the growth of the economy is sustained.

The Expansionary Policy:

The expansionary policy is also referred to as the accommodative policy. This policy reduces the short term interest rate to increase the amount of money in supply. This move by the government has the effect of increasing inflation.

The central bank uses this tool to reduce the interest rate on short-term loans. As a result of the lowered interest rate, commercial banks are in a better position to obtain more liquidity from the central bank as they take advantage of the lowered interest. This results in commercials banks charging less interest rate to their customers when they come borrowing as the government has provided them with money to loan out.

Flowing from this, companies find it easier to have access to more funds and begin to expand their business frontiers. In the course of expanding, the need for more workers increases. It thereby leads to an increase in the rate of employment.

The resultant effect of this policy is that it increases the rate of inflation, which is due to excess money in circulation. It also helps to boost the economy as more capital investments are made that further strengthens the economy.

How Does Monetary Policy Affect Interest Rates Indirectly?

Like it is mentioned earlier, monetary policy also affects the interest rate indirectly. When the government makes policies that are targeted at preventing inflation, it has an indirect effect on the interest rates. This is because when it is perceived that inflation is to rise, the government adopts monetary policies that determine the federal fund rate. This, in turn, affects the interest rates that banks charge for lending and borrowing of money.

The relationship between inflation and interest rate is such that whenever the interest rate is reduced, the economy begins to blossom. As a result, there leads to an increase in the rate of inflation. So, when the government employs other measures to tackle inflation, it still has an indirect effect on the interest rate. In the same vein, when the interest rate increases, the pace of the economy is reduced, and the rate of inflation also reduces. Thus, it can be said that there exists a correlation between the monetary policies that seek to tackle inflation and interest rates.

Inflation And Monetary Policy

At the heart of monetary policies lies the need to control inflation. Inflation refers to the increase in the price of commodities across the market. It is traceable to the increase in the amount of money in circulation.

Thus, when the government, through its policies, seeks to regulate the supply of money within the economy, it is at the same time seeking to regulate inflation. When the government seeks to control the supply of money, it does not necessarily begin to print new currency notes. Instead, it employs the use of other instruments to achieve the same goal.

One of the instruments used by the central bank to control the money supply is known as open-market operations. In this manner, the government gets involved in the buying and selling of bonds. It is a move made to facilitate access to loan facilities, and as a result, more companies can invest and expand their market.

Another instrument used by the government through its central bank to regulate money supply is through the regulation of the discount rate. The discount rate is the interest rate charged by the central bank on loans taken by commercial banks. This aspect has been exhaustively discussed earlier on.

The government also uses reserve requirements as an instrument to control the money supply in the economy. Ordinarily, the central bank serves as the bank to all other commercial banks, and as required by the laws establishing the central bank. The commercial banks maintain a reserve account with the central bank, where it keeps a certain quota of its deposits with the central bank.

The reserve requirement is a percentage of the money that the commercial bank owes to its customers. The reserve requirement acts as a limit on the lending powers of a commercial bank as the commercial bank cannot give out loans to its customers beyond the reserve limit. The regulations set out by the government per time have an effect on the powers of the commercial banks to borrow and the amount of money they can give out as loans per time.

Not all nations of the world frequently modify their reserve requirement as a measure to tackle the money supply. Nations like the United States, Russia, China, India, and Brazil fall into this category. It is based on the premise that the move of modifying reserve requirements to control the volume of money in circulation in the economy affects the financial markets.

The Role Of The Central Bank In Monetary Policy

It has been stated earlier that monetary policies are the decisions and acts of the central bank. It must be noted that the role the central bank plays in introducing and adopting monetary policies are roles that it plays while acting as an agency of the federal government. Thus, the decisions and acts of the federal government, in this regard, are deemed as acts of the federal government.

The role of the central bank includes introducing, implementing, and monitoring of monetary policies. It is the only body vested with the powers to print the currency of a particular nation. The central bank also acts in a supervisory capacity over the commercial banks and is expected to discharge its responsibilities independent of any political control.


The government, through its central bank, is primarily involved in regulating the economy of a given nation. In examining the regulation of economic activities by the government through its monetary policy, a pertinent question has been raised. This question is, how does monetary policy affect interest rates? It has been discovered that monetary policy affects interest both directly and indirectly.

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