Basics of Central Banking
Updated: Feb 7
The interest rate plays an important role in the housing market. But what exactly is the interest rate? Who sets it? Why does it change? To answer those questions, we need to understand central banks and their role in the monetary system.
The central bank of a country is responsible for regulating monetary policy. The central bank has the sole authority to make new money. They are tasked with controlling inflation and insuring a strong economy. Generally, central banks are politically independent, allowing them to focus on their mission of maintaining financial stability without being affected by the government's other priorities.
How does the central bank fulfill its mandate to insure low inflation and a strong economy? Simply put, it does so by controlling the supply of money. However, it gets very complicated, very quickly. One key issue for central banks is that their two missions are almost at cross purposes. Why? Inflation results when there is an excessive amount of money available. The monetary supply grows, but the amount of goods and labour available remains constant. Therefore, the amount of money required to obtain a good or service increases. This is inflation. While some inflation is considered economically beneficial, excessive inflation causes dramatic increases in the cost of living.
While a large monetary supply can cause inflation, a restricted money supply can have a negative effect on economic growth. This is pretty much common sense. To open a new business or expand an existing one requires capital. When there is a large monetary supply, getting this funding is easier. But with a restricted monetary supply, there is less capital available for new business ventures. This results in a general weakening of job growth.
The role of central banks is in balancing those two elements by maintain a stable monetary supply that is neither too large nor too small. In my next blog post, I'll examine what tools central banks use to control the monetary supply, including the all-important interest rate.