How does a central bank ?set? interest rates?

August 14th, 2007

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Today, one of our readers asked this question: how does a central bank ?set? interest rates? To answer this question, we will look to the Reserve Bank of Australia (RBA) as an example. For this, we will get the answer straight from the horse’s mouth (RBA), which can be found in How is Monetary Policy Implemented? on their web site.

First, we have to understand that there are many kinds of interest rates, which can be categorized into either short-term interest rates and long-term interest rates. An example of a long-term interest rates include the 10-year Commonwealth Treasury bond yield. An example of a short-term interest rate includes bank bill rates.

The relevant interest rate for today’s article is the cash-rate, which is

… the rate charged on overnight loans between financial intermediaries.

The RBA can only control the cash-rate, which

… has a very strong influence on other interest rates, and therefore helps to set the level of short-term interest rates in the wider economy.

 The RBA control the cash-rate through

… its financial-market operations and it functions as the policy instrument.

What this means is that the RBA does not ?set? interest rates by issuing a decree that has to be obeyed. Instead, it ?sets? interest rates through its Domestic Markets Department which

… has the task of maintaining conditions in the money market so as to keep the cash rate at or near an operating target decided by the Board.

In essence, the money market operation works this way:

If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall. Conversely, if the Reserve Bank supplies less than banks wish to hold, they will respond by trying to borrow more in the cash market to build up their holdings of exchange settlement funds; in the process, they will bid up the cash rate.

Basically, the RBA ?sets? interest rates by adjusting the money supply. This implies that the central bank cannot control both interest rates and money supply simultaneously?it can control either one or the other but not both.

Recommended reading for this article: What makes monetary policy ?loose? or ?tight??.