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It was top news a week ago that Bank of Ukraine increased its rate to 30%. And the news said they did this to fight inflation.

But I don't understand one thing: isn't the increased rate of "money printing" of the central bank only aggravates the problem? How is it supposed to reduce inflation?

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migrated from Mar 11 '15 at 15:02

This question came from our site for people who want to be financially literate.

I asked this to get better understanding on how central banks work. So I can know what indicators to look at when reasoning about interest rate changes in the future. – Calmarius Mar 10 '15 at 20:44
@DumbCoder Will that site graduate this time? It has been failed once, and stats aren't look good... – Calmarius Mar 11 '15 at 14:50
Hi, if you're going to cite a news article, please link it, makes things a lot easier. – dwjohnston Mar 17 '15 at 21:55

From Monetary Policy:

There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply.

Increasing rates makes it more expensive to borrow and thus slows economic growth where the US in the early 1980s would be a good example to see the recession that was had at the hand of high interest rates at the time.

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The Rate they are talking about is the rate at which the central bank lends money to other private/public banks. It has nothing to with the rate at which the central bank prints money (Infact this is the first time I have seen somebody interpreting the central bank lending rate as the rate at which the central bank prints money). By increasing the rate of interest they are tightening the money supply. As a result the rate at which the Ukrainian currency is losing its value aka inflation will decrease.

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I thought that the central bank rate is the interest rate the bank pays after deposits commercial banks hold at them. Isn't it? – Calmarius Mar 10 '15 at 22:33
When talking about Central Banks the Interest rate almost always refers to the Bank's lending rate. Even if you consider it as the interest rate the bank pays to its customers, an increase in the rate of interest on deposits will be accompanied by an increase in rate of interest on loans. The bank's lending rate is always higher that it's rate on deposits. – acoolguy Mar 10 '15 at 22:59
@Calmarius There's always a bid and an ask whenever you buy/sell things. Similarly for interest rates, they're called the deposit facility rate and the marginal lending rate. The rate you were thinking is the former, but news stories usually do not talk about it (unless it's negative as ECB's current deposit rate). – hroptatyr Mar 12 '15 at 6:17

When we talk about inflation, it helps to look at where the money goes after it is "printed." More accurately, written down as a loan on another bank's balance sheet.

Let's imagine that the central bank loans a bank 1,000, and has a 10% reserve requirement. That bank can loan out 900 of the original 1,000. The borrower then pays for goods/services, and the person paid deposits the money in their bank.

Now, there is 1,900 in the system; The original 1,000 which exists as 100 in bank reserves and 900 loaned out, plus the 900 deposited. Inflation, therefore, is not only from money printing, but also the ability of fractional reserve banking to 'create' money through the loan process described above. If you do the math, a 10% reserve requirement will ultimately let you multiply the original money by a factor of 10, a 5% reserve requirement will multiply it by 20, etc.

With this in mind, here's how you can speed or slow inflation:

1) By changing the monetary base, you can change the base amount of money that can be multiplied in the fractional reserve system. So, when a central bank creates new money, the total possible amount of money in the system increases proportionately. However, the money must be loaned out and re-deposited many times to reach the highest possible amount: hence the next two items.

2) By changing the reserve requirement, you can permit banks to loan out more of the money they have, which permits more money to be created via the banking system. In our above case, with 1,000 to start, changing the reserve requirement from 5% to 10% would decrease the total possible money supply from 20,000 to 10,000. This is as powerful or moreso than the original money printing.

3) Finally, the multiplication mentioned above can't happen if the money isn't loaned out. Therefore, with very low interest rates, borrowing is easy, the money supply expands via fractional reserve banking, and we get inflation. If you raise the interest rate significantly, people stop borrowing, start saving and paying off debt, and the money supply drops.

All three can affect inflation/deflation, but the key here is that borrowing drives the money supply as much as the central bank's creating money drives it. Since banks borrow money from the central bank, they must lend at higher rates than they are borrowing in order to turn a profit, so setting the interest rate is a potent means of encouraging or halting inflation.

Finally, for "what about printing while raising rates?" If the central bank is creating money to buy government debt, it is likely that the high interest rates are meant to prop up the value of that debt, so the government can continue to make expenditures. At the same time, it's nearly impossible for civilians to borrow. I don't know the monetary rules for the Ukraine, but I will speculate that their central bank is trying to keep the government funded (given the political situation) by diverting money away from other sectors.

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