In free market economies, consumers and business can do almost anything they want with money-as long as they pay for it. Therefore, by controlling interest rates-the “cost” of money- central banks can greatly influence economic activity.
In a totalitarian country, the government can simply tell its citizens what it wants them to do: today you will be bread, tomorrow you will not. But in free-market countries, consumers and business are encouraged to increase or reduce their economic activity through economic incentives.
For example, when a central bank decides that an economy is growing too slowly-or not growing at all-it reduces the interest rate it charges on its loans to banks. When banks get “cheaper” money at the central bank, they can make cheaper loans to business and consumers, providing an important stimulus to economic growth. Likewise, by raising interest rates, a central bank can slow down an economy. When interest rates go up, people don’t buy as many houses, cars, and restaurant meals- and economic activity declines.
Since most banks borrow money from central bank, the interest rate the central bank charges affects further lending throughout the economy. When a central bank changes its discount rate, the interest rate it charges for loans to banks, interest rates across the economy almost always follow suit. The interest rates on loans made between banks-called interbank rates in Europe and Fed Fund rates in the United States- logically will rise whenever banks have to pay more to borrow from central banks. The higher cost of money is almost always passed on the consumers and business in the form of higher interest rates-on credit card debt or home loans, for example.
All interest rates are linked, of course, because money, like most commodities, is interchangeable. Banks and individuals will go wherever rates are lowest-basically, whenever money is cheapest. A change in interest rates in Los Angeles, but will often affect international money markets, interest rates have become the heartbeat of economic activity.