How and why does it cost more to borrow money? Where does the extra money from interest go to? The borrowing bank or central bank?
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The interest rate that we talk about here is the inter-bank overnight rate. Basically, all banks have to keep a specific fraction of their total deposits on deposit with the Federal Reserve. If they are short, the bank can borrow some cash from _other_ banks to make up the shortfall; if they are over, they can lend that cash to other banks. The Fed sets the target rate for those transactions, but the individual banks are the ones paying and receiving this interest.
This ripples throughout the economy, because as that rate gets higher, two things happen:
– It is more expensive to potentially fall short of your deposit requirements, meaning that you are less likely to make additional loans (or need to charge more for said loans to offset that risk).
– It is more profitable to simply lend to other banks rather than consumers, as banks are much lower risk.
Either way, the result is the same – fewer loans to folks and loans at higher interest rates. This slows down the velocity of money, which will act as a curb on specific types of inflation and economic growth.
The central bank interest rates set the base rate for interbank lending. So if bank A needs more funds it borrows from whichever bank has excess funds to lend it. This generally washes out over time between the banks but this means that ALL banks end up with higher costs of borrowing and therefore lend less money out and charge higher interest rates to other borrowers.
The interest rate therefore is like the “speed regulator” of money movement in the economy. Higher rates means lower loan activity (generally) and lower rates mean higher activity. Businesses and people rely on short term and long term loans. So increasing their costs also means businesses and people are inclined to spend and invest less. Lower activity tends to lower demand and generally means price increases (inflation) are also reduced.
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