Interest rates are determined by the supply and demand of the market, but the government adjusts the base rate to control the flow of the economy. Why does it work this way? This article explains the difference between the market rate and the base rate, the role of the government, and the impact of interest rates on the economy.
The Role of Market and Base Rates
In a capitalist society, prices change in response to supply and demand. Interest rates can also change in response to supply and demand. If people want a lot of money, the interest rate, which is the charge for using money, goes up. Conversely, if fewer people want to spend money, demand decreases and interest rates fall. The interest rate that the market sets according to the supply and demand of money is called the “market interest rate.
If market interest rates are allowed to rise and fall at will, it will have a huge impact on the economy as a whole. Let’s say you leave a four-year-old child with a lot of energy at home without a guardian. You cannot kick the child out of the house just because he or she has turned the house upside down. Parents who leave their children alone have a greater responsibility. Similarly, the governments of each country should take on the task of properly controlling and managing interest rates as if they were four-year-olds. A typical method of control is to set a “base rate.
The basic interest rate controls the speed of the flow of the economy
The policy rate is set by the central bank of each country, and in the case of Korea, it is set by the Bank of Korea. The market interest rate is determined by adding the base interest rate to the bank’s profit and other additional interest rates. If we compare the flow of the economy to a car, the market interest rate is the speed at which the car runs, and the base interest rate is the accelerator and brake that control the speed of the car. The steering wheel of this car is held by the Bank of Korea. The people are the passengers in the back seat. The passengers demand that the driver arrive at the destination safely and on time. Therefore, the driver should not speed recklessly in the hope of reaching the destination quickly (high-speed economic growth) or insist on driving slowly (no-growth populism) while shouting “safety first”.
To have a basic understanding of economic common sense, it is good to know about the Federal Reserve. Why the Federal Reserve of the United States? Because the United States is the center of the global economy. The United States is a key country that controls the flow of money around the world. This can be seen by the fact that the US dollar is used as the “key currency”. We will return to the key currency when we introduce the exchange rate.
The central bank in the United States is called the Federal Reserve System. So in Korea, the chairman of the Financial Policy Board, who is the president of the Bank of Korea, announces the policy rate, but in the United States, the chairman of the Federal Reserve Board announces it.
As I mentioned earlier with the car analogy, the safety and speed of the economy must be balanced. If you go too fast or too slow, you will have problems. Lowering the federal funds rate is like a driver stepping on the gas. When the base rate goes down, the market rate goes down. Since the cost of using money has become cheaper, it is easier to spend money. Therefore, consumption and investment increase. As demand increases, supply must also increase. Businesses produce more and factories expand. Households need to hire more people, so household income also increases. In the end, the overall economy improves.
Base rate ↓ ⇨ Market rate ↓ ⇨ Consumption ↑ ⇨ Investment ↑ ⇨ Production ↑ ⇨ Employment ↑ ⇨ Economic Growth
On the other hand, raising the federal funds rate is like slamming on the brakes. When the policy rate rises, the market interest rate also rises. It becomes difficult for people to spend money, and consumption and investment shrink, so corporate profits also decrease. Companies reduce production and lay off workers. The unemployment rate rises and the economy worsens.
Policy Rate ↑ ⇨ Market Rate ↑ ⇨ Consumption ↓ / Investment ↓ ⇨ Production ↓ / Employment ↓ ⇨ Economic Downturn
When news comes out that the key interest rate will be lowered or raised, we can guess the overall economic trend. When it is announced that the key interest rate will be raised, we should reduce consumption and especially borrowing. Instead, we should increase our deposits, so we should prepare our bullets (cash).
As the U.S. continues to raise interest rates sharply from the end of 2021, the words “big step” and “giant step” are widely used. The federal funds rate usually moves by 0.25%p, which is called a “step”. If the rate goes up by 0.5%p, which is twice the normal step, it is called a big step, if it goes up by 0.75%p, which is three times the normal step, it is called a giant step, and if it goes up by 1.0%p, it is called an ultra step (there has never been an ultra step). If you know these expressions, you can immediately understand what they mean and how much the interest rate will rise when you see a headline like the one above.
Today, the whole world is interconnected. In this situation, changes in the U.S. federal funds rate will inevitably affect the Korean economy. The international economy is more complex, but let’s look at it in a simplified way. If the U.S. federal funds rate rises, you can earn a lot of interest if you invest in the U.S. It’s easy to think of this as saving money in a bank in the United States. More people invest in the United States because they get a lot of interest. People who invested in Korea take that money out and put it in the United States. When the number of people investing in Korea decreases, the stock prices of Korean companies decrease. This leads to a downturn in the Korean economy.
To prevent this from happening, South Korea can raise its benchmark interest rate when the U.S. raises its benchmark interest rate. Usually, South Korea’s policy rate is higher than the U.S. policy rate. However, there are exceptions. Very rarely, the situation where the US base rate is higher than South Korea’s is called “rate inversion”. When looking at interest rates, you should not only look at South Korea’s interest rate, but also the U.S. interest rate.
The mission of the Bank of Korea: Regulate the flow of money!
The Bank of Korea’s monetary policy is to set the policy rate to regulate the overall economy. Money is the flow of money, and the amount of money is the amount of money flowing in the market. In other words, monetary policy is to increase or decrease the amount of money circulating in the market (my pocket, the company’s pocket, the government’s pocket). The central bank plays an important role in the national economy, so the government cannot control it at will, so the Bank of Korea operates independently. Currently, the Bank of Korea is located near Sungnyemun Gate in Seoul and does not accept deposits from the general public. However, it has a “bank” sign because it is an institution that manages the lifeblood of the Korean economy, the money supply.
At what level should the economy be adjusted? The goal of monetary policy is to stabilize prices. In general, prices are considered to be stable when the rate of consumer price inflation is maintained at around 2 percent (the target value is continuously revised according to the current economic situation). The appropriate price level is determined in consultation with the government. This shows that even though the Bank of Korea operates independently, it cannot be completely separated from the government.
In this blog post, I will not mention the means used by the Bank of Korea to adjust the policy rate. If you want to know more about it, type “payment reserve rate,” “open market operation,” and “re-discount rate” in the search box. It will be helpful to know, but you will not be greatly affected in your daily life if you do not know.
What is the difference between quantitative easing and quantitative tightening?
The words “quantitative easing” or “quantitative tightening” often appear in economic news. Quantitative easing means increasing the amount of money in the market, and quantitative tightening means the opposite. I mentioned earlier that the amount of money in circulation is controlled by the central bank through the federal funds rate. Why is quantitative easing or tightening necessary? This concept came out of the global economic downturn. In a recession, the governor of the Bank of Korea can implement the following monetary policies.
Economic downturn ⇨ Lower policy rate ⇨ Increase consumption / increase investment ⇨ Increase production / increase employment ⇨ Economic recovery
However, a problem arises when the central bank tries to lower the policy rate. Lowering the policy rate is based on the premise that there is something to lower. If the federal funds rate is 0%, there is nothing to lower. Some countries have negative interest rates, but most do not.
How can we lower the cost of using money if we can no longer lower the base rate? It’s easy to think in terms of supply and demand. To lower the price, we simply have to increase the supply. It’s only natural that when there’s more money, the cost of using it will go down.
Monetary policy is a method of setting a target interest rate and indirectly increasing or decreasing the money supply through various stages. Simply put, it makes people take out the money they have in their pockets or put the money they were going to take out back in. On the other hand, quantitative easing is when the government steps in and directly adds new money to the market. As the name suggests, it is a policy of quantitative easing.
Quantitative easing is accomplished by the government issuing government bonds or buying financial assets. This is often referred to as “printing money”. Of course, this method has its downsides. Issuing government bonds means that the government is in debt, and buying financial assets also means that the government is spending money. Therefore, the longer quantitative easing continues, the more the government’s debt will increase. If we want to prevent the country from going bankrupt, we need to reduce quantitative easing. Stopping quantitative easing and withdrawing money is called quantitative tightening. The method is to move in the opposite direction of quantitative easing, such as stopping the purchase of financial assets.
