# Understanding interest rates

When a central bank 'pays' interest rate X / year, what does it mean exactly? Is that pure money printing? Where does that money (interest rate) come from? does it increase the debt of the country?

A popular way to fight high inflation is to increase interest rate, but doesn't that mean printing more money -> more inflation?

Thank you!

• "A popular way to fight high inflation is to increase interest rate" Can you back this up with some sources please? Oct 14 '18 at 8:20
• Oct 14 '18 at 8:26

The usual modern practice is for central banks to set a policy rate, which is where it wants short-term (often overnight) interbank lending rates to be. This then becomes the reference rate for other interest rates. An interest rate is just the cost of borrowing (expressed as a percentage per year); it is itself not money.

The rate of interest is set to achieve policy objectives, such as controlling inflation. (I will not attempt to answer the part of the question whether raising the rate of interest itself causes inflation, as that us extremely controversial.)

There is no need for the central bank to actually pay that rate of interest on anything, as I will discuss later.

It is possible for private banks to borrow at that interest rate from the central bank. In the United States, that would be discount window borrowing. Banks would do this if they need funding and cannot get it elsewhere (it is normally frowned upon). The discount rate is another policy rate that is set as a spread to the main policy rate (the fed funds rate). However, since the private bank is borrowing from the central bank, money is flowing from the private sector back to the central bank, reducing the money supply.

Pre-2008, the Federal Reserve did not pay interest on balances held at it by banks (“reserves”). That is, it could keep interest rates at a target level without paying interest to do so.

However, it now pays interest on reserves. It needs to do so now in order to keep inter-bank rates at its target rate as a result of the decision to create large amounts of excess reserves (“quantitative easing”). The payment of interest by the central bank creates “money,” since balances at the central bank are part of the money supply. (This might be termed “money printing,” but that phrase is somewhat vaguely defined.) The increased balances are created by the central bank adjusting upwards private bank balances (in the same way private banks do to their customers), so the money “appears out of nowhere.”

Does this payment increase the debt of the country? Not by standard definitions, since they usually equate governmental debt to the amount of bonds/bills issued by the fiscal authority (the Treasury in the United States). However, it increases the money issued by the central bank, and money is a liability of the central bank. Since the central government owns the central bank, this means that governmental liabilities are higher.

When a central bank 'pays' interest rate X / year, what does it mean exactly?

It means that by lending to the central bank \$100/(1+X) at the beginning of the year, the central bank will pay \$100 at the end of that year.

A popular way to fight high inflation is to increase interest rate, but doesn't that mean printing more money -> more inflation?

Not necessarily. Increasing the interest rate may attract cash flows from foreign lenders/investors. The effects of it on the exchange rate (appreciation of the local currency), currency reserves, and/or trade balance tend to alleviate the need to merely print more money in the local economy.

You need a clear understanding of interest rate.

Interest rate is nothing but the opportunity cost of holding money. It is the price you pay for the cash in your wallet. It is the price of present consumption.

Now think a level deeper. You have some cash in your wallet or in your house. What were the other opportunities of using that cash? You would have invested that cash and let's say you would have done a small business and earned a profit.

You plan to keep it in the bank and authorise the bank to use that cash for a stipulated time. Now your bank should compensate you with a part of productivity that your cash would generate. Your cash is actually a capital that earns a return. So rate of interest is nothing but rate of return on your investable cash. If there is no investment there would not be any rate of interest because further value could not be generated without investment.

Now inflation could be controlled by increasing the rate of interest in a closed economy. Higher rate of interest would discourage investor to take loans and invest. Higher rate of interest would also discourage households to hold liquid cash and decrease spending thereby decrease their demand which would exert a downward pressure on prices.

The higher interest rate never means printing more money instead it means printing less money.

See, the interest rate is nothing but the price of money which is determined from the intersection of money demand and money supply curves. When you increase the money supply that is you print more money you tend to decrease the price of money that is the interest rate and vice verca.

Hope this explanation brings in conceptual clarity.

• There is some confusion here. Yes, higher rates will exert the deflationary effect you describe, which is in line with other effects I outlined in my answer. But these effects aside, if lender paid \$95 to the central bank for a zero-coupon bond with face value of \$100, the central bank will eventually need to print \$5 in order to honor both its debt (\$95) and its promise (\$5) at the end of year. Printing of money need not happen at the same time the rates are raised, but consumer's decision not to spend \$95 on consumption today does not void the bank's duty to pay the extra \$5 later on. Oct 14 '18 at 21:38 • You're right:$95 in year 2018 is worth $100 in year 2019. When bank sells bonds in an open market it is contractionary monetary policy ie it decreases purchasing power and income and when it repurchases the bonds it is expansionary fiscal policy. The effect you describe is first monetary expansion then subsequent contraction. You are confusing between nominal money and real money. When you are printing money, the output also increases on the supply side with the productivity you generate. Hence$ 5 may be printed, but it is backed by real output which your $95 generated. Oct 15 '18 at 1:25 • Whether the \$95 lent to the central bank generated any productivity or real output (with which to back the extra \$5) is debatable. First, because those \$95 are neither spent on consumption nor invested, but removed from the economy, thereby rendering the \$95 unproductive. Second, bc the purpose of a central bank is to procure and maintain currency stability rather than to stimulate the economy. It is true that the U.S. Federal Reserve also pursues (or pursued at least in the Great Recession) full employment, but that hybrid or dual mission departs from the strict purpose of a central bank. Oct 15 '18 at 21:13 • When you think in an macroeconomic framework, the central bank does not inject all the money it has in the economy all at once. Some people would have purchased bond worth$95 for 1 year, some for 2 years and some for even 10 years. When central bank is repaying you your money, it is parallelly issuing more bonds to suck more money. So inflationary impact depends on the relative magnitudes of money injected or leaked and also on how supply side is reacting. Inflation is multidimensional. You cannot distil only one factor, and evaluate its inflationary impact. Oct 16 '18 at 4:55

So, a central bank sets the interest rate of the instrument of money that it deals in. Example, the Reserve Bank of India (RBI) sets the repurchase rate (repo rate) at which it will buy or sell money against treasury bonds as collateral. So, if the repo rate is 5%, it means that Commercial Banks (bank) can borrow funds from the RBI (by giving treasury bonds as collateral) at 5%.

This is separate from the Open Market Operations (OMO) that a Central Bank performs to control money supply (liquidity) in an economy. So, a Central Bank can announce bond sales or redemptions. If there is a bond sale, the Central Bank will sell the treasury bonds that it holds as assets and accept dollars from the purchasers (typically Banks). In this case the money supply in the economy goes down. The opposite effect occurs when bonds are redeemed/purchased back. The bonds are purchased by the Central Bank and it pays money to the bondholders releasing money into the economy.

In the second case of OMO where the Central Bank pays money to the bondholders, it actually prints money. Similarly, if the Commercial Banks borrow from the Central Bank using the repo mechanism, the latter will print money to lend at that rate.

In reality, Commercial Banks opt for Central Bank borrowing as a last option and opt to borrow money from other Banks where collateral free loans are available (albeit at a higher rate).

Further Reading: There is a reverse repo rate at which the central bank can borrow money from the bank, say at 4%. So, effectively this sets a floor interest rate of 4% for the bank since it will at least get that much and a ceiling rate of 5% at which bank can borrow from the Central bank. The difference 1% is Central Bank's profit.