Monetary Policy deals with the supply of money in the economy. The country’s government controls, through the Central Bank, how much money is out there circulating in the country. It is concerned primarily with decisions about interest rates.
Example 1: In the UK and in the European Union, changes in interest rates are determined by the base interest rate set by the central banks – The Bank of England and The European Central Bank respectively.
The interest rate is the price of money. First, when it comes to the cost of borrowing money from the bank. And second, when it comes to the gain of saving money in the bank.
Interest rates determine two things:
- How much it is going to cost a person or a business to take a bank loan?
- How much money an individual or a business can earn when depositing money with the bank?
Mainly, the government, together with the Central Bank, uses interest rates to influence business activity – maintain high economic growth and keep low inflation.
How can the government adjust interest rates?
The government can make changes in the interest rate to either supply more money into the economy (by lowering interest rates). Or, it can take some money away from the markets (by increasing interest rates).
Lowering interest rates (↓)
The economy is believed to be slowing down and entering into the recession stage. The economic growth is declining and there is a danger that unemployment might rise. Inflation is low and is forecasted to remain below governmental targets. The government and the Central Bank may decide to reduce interest rates to stimulate businesses and customers.
Money is cheaper now.
Increasing interest rates (↑)
The economy is believed to be growing too fast and entering into the boom stage. The economic growth is increasing and the economy is reaching the overheating stage of the growth phase of the business cycle. There is a danger that inflation will rise above the targets set by the government. The government and the Central Bank may decide to raise interest rates to combat the effects of inflation.
Money is more expensive now.
In summary, the increase or decrease in interest rates will have very significant impact on the whole economy, businesses and customers. So, it is always important for a business manager to evaluate the possible impact of interest rate changes on the business.
Even small changes in interest rates could be very important for companies with high debt (high Gearing Ratio over 50%), or for those businesses that are relying on loans to support their external business growth.
