A group of people in a meeting room can make a $10M racing loan cost $400,000 a year more or less. They never see your car. This week: who they are and which levers they pull.
Learning objectives. After this week you can (1) name the central bank's three classic tools; (2) tell expansionary from contractionary policy; and (3) show how a rate change moves a borrower's interest bill.
Remember this: lower rates push spending up. Higher rates cool it down.
1) What the central bank does
The central bank (in the U.S., the Federal Reserve) runs monetary policy: it manages the money supply and steers interest rates to keep prices stable and the economy healthy. It is also the lender of last resort, lending to banks in a crisis. Taxes and government spending are fiscal policy, set by the government, not the central bank.
2) The three classic tools
- Open market operations: buying or selling government bonds. Buying pays out money and grows the money supply; selling pulls money in.
- The policy rate: the rate banks charge each other on overnight loans (in the U.S., the federal funds rate). Other borrowing rates follow it.
- The reserve requirement: a higher requirement means banks can lend less (Week 2's multiplier shrinks).
| Goal | Policy | Actions |
|---|---|---|
| Lift a weak economy | Expansionary | Lower rates, buy bonds, cut the reserve requirement |
| Cool inflation | Contractionary ("tightening") | Raise rates, sell bonds, raise the reserve requirement |
3) What a rate change does to a borrower
Yearly Interest = Loan × Rate
Example. Racing loans price at the policy rate plus 4 points. At a 6% policy rate a team borrows at 10%: a $10,000,000 loan costs $1,000,000 a year. The central bank cuts to 2%, the team now borrows at 6%, and the same loan costs $600,000. That $400,000 of savings is how a rate cut makes borrowing and spending more attractive.
Quick self-check
(a) To fight inflation, does the central bank raise or lower rates? (b) When it buys bonds, does the money supply rise or fall? (c) A $5,000,000 loan goes from 6% to 10%. How much more interest per year? (Answers: raise; rise; $200,000.)
Common mistakes
- Mixing up the two policies. Rates and money are monetary; taxes and spending are fiscal.
- Getting bond buying backward. Buying bonds puts money in; selling takes it out.
- Thinking a rate cut is free money. It lowers the price of borrowing; the debt is still owed.
This week in the arena
Your team has no credit line, so your spending is capped by your cash, like an economy where money is tight. Price your planned budget two ways: borrowed at 6% when rates are low, and at 10% after tightening. How much of a race's Winnings would each interest bill eat?