• Monday, February 26, 2024
businessday logo

BusinessDay

Explainer: How central bank’s interest rate impacts people, economy

How reforms can boost productivity as money supply rises 77%

The Central Bank of Nigeria (CBN) commenced a series of hikes in its benchmark interest rate in May 2022 and raised the Monetary Policy Rate (MPR) from 11.5 percent to 18.75 percent in July 2023.

The major reason for the continued interest rate hike was to rein in inflation, which stood at 27.33 percent as of October, according to the National Bureau of Statistics.

How do central banks achieve price stability?

One way they do this is through interest rate, which is the cost of borrowing money. Central banks lower interest rates, making credit cheap, to boost the economy because people need credit to buy things such as homes and food.

Read also: CBN delays MPC meeting again, leaves investors guessing

When prices get too high, central banks can raise rates, making money more expensive to borrow. This can slow growth but it also brings down prices.

How does the central bank’s interest rate impact the economy?

When policy rates are low, the cost of borrowing money is cheaper in banks. So they charge households, companies and governments low interest rates. This will have a ripple effect throughout the entire economy. Lower interest rate means a lower cost for borrowing loans or lower payments on existing loans. This drives up spending, investment, demand and as a result there is increase in overall economic activity. Sometimes the balance between the supply and demand for goods and services and the economy can go off track like we have seen over the last year, according to the International Monetary Fund.

How a change in interest rate by the CBN affects people and the economy

The CBN may decide to make a change in MPR, which is its official interest rate that anchors all other interest rates in the money market and the economy. CBN’s decision on the MPR affects the level of economic activities and prices in the country through a number of channels.

A decision by the CBN to change the MPR affects the market interest rate in different ways. When the apex bank makes an announcement on the MPR, it affects the expectations of people and economic agents about the future direction of the economy. Such decisions also affect the prices of financial assets (like shares) and the exchange rate of the naira to other currencies as well as the ability of people and economic agents to save and spend money. For instance, when the interest rate is increased, people are encouraged to save instead of spending their money.

An increase in interest rate would also lead to foreigners paying more to buy the local currency, thereby making foreign goods to be cheaper than goods produced in the country, and vice versa. This could encourage imports and discourage exports of goods and services. This has a limiting effect on our level of external reserves. Thus, when the CBN makes a change in interest rate, it affects the exchange rate. Although the change in exchange rate may directly affect domestic prices of imported goods and services, this effect may not be immediate. Also, the change in interest rate could generate an indirect effect on the prices of goods and services which compete with goods that are domestically produced or those goods and services that use imported raw materials. Consequently, a change in interest rate has an effect on the component of the general price level of those goods that are imported and this affects all economic agents in the country.

Other implications of the rate hike?

According to Ayodeji Ebo, managing director/chief business officer at Optimus by Afrinvest, higher interest rates can encourage people to save more as they can earn a higher return on their savings.

“However, this is subject to other conditions which vary across banks, like limits on the number of withdrawals per month to qualify for interest. Increased savings can also be beneficial to the economy in the long run as it can increase the amount of money available for investment, which can help boost economic growth.”

Read also: CBN’s failure to hold policy rate meeting in two months draws intense focus

He said while an increase in MPR can make fixed-income securities more enticing to investors, following a repricing of these assets, yields appear to be heading in the opposite direction.

“Despite the potential benefits of higher interest rates in attracting foreign investors seeking better returns, Nigeria’s current economic conditions have deterred such investments. The dollar shortage and unattractive yield environment have made it less appealing to foreign investors.”