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 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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