How Monetary Policy Affects Loan Interest Rates

It is important to first understand the meaning of monetary policy. Monetary policy is conducted by the central bank, like Reserve Bank of India. Monetary policy is concerned with demand and supply of money. When the central bank pursues expansionary monetary policy, it increases the supply of money in the economy. When the central bank pursues contractionary monetary policy, it reduces the supply of money in the economy.

Central banks increase or reduce the supply of money in the economy, mainly through open market operations. A central bank buys and sells government securities in open market operations. When it wants to increase the supply of money in the economy, it buys government bonds from the market. It releases more money in the economy by making payments for the government bonds that it has bought. When the central bank wants to reduce money supply in the economy, it sells government bonds. The payments that it receives from the market for selling these bonds effectively reduces the supply of money in the market or economy.

Central banks can also affect the supply of money in the economy by using tools such as increasing cash reserve ratio , statutory liquidity ratio etc. for banks. With increase in these ratios, banks have lesser money to lend. Lower amount of lending by banks also brings down the supply of money in the economy. When the central bank intends to increase the supply of money in the economy, it can reduce these ratios.

The purpose of central banks in changing demand and supply of money in the economy is to affect interest rates. When the central bank wants to increase interest rates, it reduces the supply of money in the economy. When the central bank wants to reduce interest rates, it increases the supply of money in the economy. The cost of money is the interest rate that is paid on it. When there is more money supply in the economy, the cost of money or interest rate goes down. When there is less money supply in the economy, the cost of money or interest rate goes up.

And so when the central bank follows an expansionary monetary policy, and increases the supply of money in the economy, the interest rate on your gold loan, business loan and personal loan also goes down. And when the central bank follows a contractionary monetary policy, and reduces money supply, the interest rate on your loans also goes up.

Central banks follow expansionary monetary policy when they try to give a boost to a slowing economy. They follow a contractionary monetary policy when they try to bring down a rising inflation rate.