Idiot question on interest rates

Forgive my apparent ignorance, but could someone please explain the importance of central banks in setting interest rates.

As important and powerful governments and banks may be, surely prevailing interest rates are such as to balance the supply of money for loan with the demand for money to be borrowed.

How come, therefore, interest rates shift in response to central bank rate changes and governments are able to use interest rates to control inflation etc?

Reply to
Caversham
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The simple answer is that if people can lend to the government at that rate. That means lending to riskier clients has to be at a higher rate to offset the risk.

Thom

Reply to
Thom Baguley

The FED has the power to raise/lower reserves (not very effective usually), raise lower the rate at which they lend and borrow to banks (usually effective) and that primes the pump for expansioary and restrictive money supply.

Recently the FED lowered rates to 45 year lows, but at the current level the net effect is pushing on a string. Successful rate management should preceded economic conditions not reac to them. Hence expect the FED to raise rates this year first quarter next, ceteris paribus.

These raises in the discount rate will be the signal to the markets that all is well. Forward looking as Greenspan has been, this raise is expected and will not be considered a negative to most FED/market watchers.

Remember, if the FED wants to add liquidity, all they need to do is open market operations and buy bonds. Conversly remove liquidity and sell them. While you may wish to bet against the FED, they do have the printing presses.

Remember their goal is always to make it easier/harder for banks to lend to businesses.

Open market actions and rates are their greatest effective tool.

Now, supporting a dollar or a pound in the open market, is suicide and typically counter productive.

Reply to
David Palmer

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