Role of Central Banks in Controlling Interest Rates and Inflation in the Economy

What Is The Role Of Central Banks In Controlling Interest Rates And Its Effects On The Inflation In The Economy?

What Is The Relationship Between Rate Of Inflation And Rate Of Interest Rates?

What Is The Effectiveness Of Monetary Policy In Controlling The Inflation Rate Of The Economy?

What Is The Relationship Between Independency Of Central Banks And Rate Of Inflation Which Is Measured From The Change In Interest Rates?

The independence of central bank is described as the freedom of the monetary policy makers for direct influence of government and political systems. The aim of the Central Banks is to be more active and independent of the political considerations that can have a long lasting effect on the economy. It targets to keep a low rate of inflation irrespective of the situation that political costs can actually raise the interest rates. The officials of the central banks are appointed by the government who targets to lower the inflation rate for balanced economic growth and a positive demand for goods and services. This is mainly done by the usage of monetary policy where the government tries to balance the business and economic cycle by keeping a lower rate of interest.  

Central banks are actively dependent on the rate of inflation that can effectively change the banking structures, policies and profits. Inflation denotes the rate at which prices are rising in the economy with respect to rise in aggregate for goods and services. This rise in aggregate demand for goods is donated by the availability of money supply in the economy that can adequately change the price of goods and services in the economy.  According to Mishchenko et al. (2018), the money supply in the economy is effectively controlled by the central banks which is based on the change in interest rate. The money supply is adjusted by changing the interest rates that is used as an effective measure for balancing the money supply during inflation. Therefore, it can be said that the independence of the central bank is governed by interest rates as they target to keep a lower interest rate.

According to central banks, interest rates are effectively balanced such it impacts the inflation rates. Interest rates of banks is used an effective tool in controlling the inflation of economies. It is used as a macroeconomic indicator to control the economic activities and control any negative effects that can hamper the growth of the economy. The rise in level of overall price of goods is known as inflation that raises the overall living cost and reduces the ability of purchasing goods and services in the economy (Ishaq and Mohsin 2015). During inflation, rate of interest will go up as the purchasing power of the lenders has increased and they demand a higher value to be returned. Moreover higher interest rates lowers the aggregate demand and helps to control inflation.

Research Hypothesis

The aim of the paper denotes the purpose of the paper which is to evaluate the independence of central banks to change the interest rate for targeting a lower rate of inflation. This can be done by evaluating the effectiveness of interest rate as ensured by the Central Bank to control the rate of interest.

The objectives of the paper are focused on establishing the main goals of the paper which are as follows:

• To evaluate the role of central banks in controlling interest rates and its effects on the inflation in the economy
• To establish a relationship between the interest rates and inflation
• To evaluate the effectiveness of monetary policy as a tool for controlling inflation
• To establish a relationship between the independence of central banks and rate of inflation which is measured from the change in interest rates.

As per Bodea and Hicks (2015), the hypothesis of a research paper is known as the testable or prediction proposition on which the paper is dependent. The paper assumes that exchange rate, fiscal deficit and other economic indicators has a negligible role in determination of the role of interest rates on inflation. A strong hypothesis relates the dependency of dependent variable on the independent variable and vice-versa as mentioned by Heinemann, Moessinger and Yeter (2018). Independency of central banks implicates the target of central banks in maintaining the inflation by changing the inflation rate which can be affected by other economic parameters.

The independency of central banks is actively denoted by factors like interest rates that can adequately change the value of goods and services in the economy with respect to significant effects in several measures. According to Weber (2018), central bank controls the money supply with respect to macroeconomic policy named as the monetary policy that significantly manages the money supply and interest rates with respect to demand related effects like inflation rate. It has the power to control the demand in the economy with respect to aggregate demand as per the money supply. A higher money supply attracts consumer demand for buying goods and allows investors to invest more money in goods and services that can effectively improve the economic structure (Ebeke and Fouejieu 2015). The role is to change the value of goods and the power of economic policies where changing the bank interest rates can significantly affect the demand for goods and services and help in controlling inflation. The supply and demand in the market is effectively handled by the central bank through the ejection of monetary policy as per the impact of inflation.

A high rate of inflation is followed by raising the interest rate, to lower the money supply in the economy that will lower the aggregate demand and help in lowering inflation rate and vice versa. This low availability of money supply will significantly lower supply as investors will lower the investment level as effective changes in market strategies and outcomes (Masciandaro and Romelli 2015). This can effectively improve the price of products with respect to significant changes in market policies and outcomes. The money supply is affectively denoted by a change in interest helps to balance the money in the economy which helps to lower inflation. Therefore, bank dependency is actively dependent on the interest rates which is used to target inflation.

Literature Review

The cost of borrowing or depositing money is denoted by the interest rate which acts as the principle interest rates to be used by banks for loaning or depositing a sum of money. The rise or fall in the rate of interest denotes the availability of money in the economy. This is used as an efficient tool to control the money supply of the economy that has a significant role in the inflation rate. A lower rate of interest rate facilities increase in lending opportunities to the people. This is because people can borrow money at such low interest rates and does not need to return pay a high amount at the time of maturity (Benigno and Faia 2016). This has effectively increased the price of the products as per the change in effective policies and outcomes.

 The lower rate of interest attracts investors who can buy more capital, make large equipment purchases or invest on new projects by borrowing a definite sum of money (Caporale, Gil-Alana and Trani 2018). It enables a rise in investment and expenditure along with a fall in mortgage interest payments that lowers the monthly cost of mortgage repayment. The result, is a rise in demand for goods and services for the consumers. From the supply side, production of good also goes up due to provision of gods at lower capital cost. However, a rise in an aggregate demand pushes up the price that leads to a rise in inflation which indicates that cost is not increasing faster than the paychecks. Maule and Hubert (2016) mentioned that the interest rate continues to remain low for a long time, then the inflation rate will raise by significant portion that will make cost of living severely high. This lowers the level of money in the banks and as a result the rate of interest is increased to lower the aggregate demand for goods and services. Higher interest rates, raises the living cost and cost of buying goods and services in the economy with respect to a change in adequate market effective policies and outcomes.

A small rise in rate of inflation is good for the economy as it denotes a rise in demand for goods and services. Central banks lower the interest rate in order to improve the economic performance which raises the demand for goods and services. The impacts can be significantly felt on inflation as high demand tends to raise the inflation rate. In the long run, the impact of low interest rates cannot be effective as a lower interest rate for prolonged period will also raise the inflation. Similarly, higher interest rate is good during higher inflation, but can lead to negative effects on economy if not ejected properly (Bec and De Gaye 2016). Thus, the interest rates are actively dependent on inflation which is changed on a quarterly basis as per the economic performance with respect to aggregate demand and inflation. However, according to Hubert (2019), inflation rate is not necessarily influenced by the interest rate but other economic parameters that can adequately change the market demand for goods and services.

Role of Interest Rates in the Economy

There are a range of indicators that can influence the inflation rates such as currency exchange rate, consumer price index, producer price index, employment statistics and retail trade which is independent on the decision of central banks (Juselius and Takáts 2016). This makes it significant to identify the dependent and independent variable with that will be effective for data analysis. An analysis is conducted by identifying the dependent and dependent variables. The performance of dependent variable is based on the independent variable where inflation rate is significantly based on central bank independence that is measured from interest rate (Masciandaro and Romelli 2015). Therefore, the paper will try to evaluate and establish a relationship between dependent variable inflation rate and independent variable interest rate as changes in interest rates affect inflation.

According to McLeay and Tenreyro (2019) the techniques used to collect, identify and analyze a data set is known as research methodology. It effectively addresses the type of data that will be collected for the paper for making an effective analysis which of several subsections. The types of data collection processes will be effective analyzed.

The outline of the model shows the structure of data analysis that is needed in the current research with respect to a set of objectives. The paper has been established in a coordinated manner such that the objectives are effectively understood and modelled. Data can be either primary or secondary where primary data are the first hand data that needs to be collected by the researcher, whereas secondary data is collected from secondary sources that has been presented other researchers (Łyziak and Paloviita 2017). The usage of secondary data will be effective as collection of primary data through interviews, questionnaires is very complex that can lower the efficiency of the experiment. Secondary data about interest rate and inflation rate of UK will be gathered from authentic websites, government data and other legal sources. The period chosen for the data which will be effective for the data analysis is a ten year period starting from 2004 till 2014.

The researcher uses several tools for analyzing the data which is significant as per the requirements of the study that will be effective for a significant analysis. There are four types of research philosophy such as realism, positivism, interpretivism and pragmatism.  The paper will follow the interpretivism method as it studies the data elements in an effective manner with respect to qualitative analysis. The paper will also follow the positivism approach that will conduct statistical evidence by doing a quantitative analysis with the usage of secondary sources.

Gaps in Literature

A research takes two approaches for a detailed explanation of data collection techniques such as inductive approach and deductive approach. Researchers proposes their own theory by studying the topic and data sets effectively in the inductive approach (Bordo and Siklos 2017). Formulation of new theories is very complex ad it is effective to work with existing theories which is followed in deductive approach and is applied in the paper.

The data in the paper is collected from secondary sources by the usage of government sites and authentic journals. The paper will use both qualitative and quantitative data. Therefore, the analysis will be in two ways by using secondary qualitative and secondary quantitative data.

According to Juselius and Takáts (2018), the data collected in the paper is analyzed in this section with respect to several parameters. The analysis will be done by using statistical approach by doing a correlation and regression statistics to interpret the relationship between the dependent and independent variables by taking a ten year data of the trend in interest rate and inflation rate.

Correlation denotes the mutual connection between two ore variables to establish a quality relationship between them. It is used to relate variables with each other and interpret the results in the most effective manner. This that independence of central banks to target the inflation rate is negatively related with the interest rate that can be controlled.

Table 1: Correlation of data sets

Table 1 shows a negative correlation coefficient between the two metrics such as a rise in the values of a variable will lead to a fall in the values of other variables. This indicates that when value of independent variable or interest rates are increased, the values of dependent variable or inflation rates gets decreased.

Regression statistics is used to study the standard deviation between the variables. The independence of central banks can be effective measured on how the change in interest rate can affect the inflation rates.

Table 2: Regression statistics

The closeness of the variables are measured from the value of r-square. Table 2, shows the r-square value is significantly low which proposes that the independent variable does not explain much of the variation in the dependent variable irrespective of variable significance. The regression model tells how one variable can influence the other variable which suggests that relation is nether strong or nor good as the value lives below 0.5. The significance of the experiment is denoted by interpreting the P-value which indicates is strong relationship between the two variables. An experiment by Brook and Arnold (2018) says that the regression is significant only when P-value is lower than 0.05 such that there is only 5 percent chance that the null hypothesis is correct.

Therefore, the experiment is not significant such the variables does not gave a good relationship with other. This indicates the fact that the literature gap has been significant such that inflation rate cannot be effective changed by changing the interest rates (Barnett, Ftiti and Jawadi 2018). Thus, the policy and performance of central bank is not significantly dependent on the inflation rate. This also indicates that values of the variables are not effectively dependent on each other as studied in the literature gaps. The analysis also sheds light over the effectiveness of other parameters that affect the inflation rate. Thus, it can be said the central banks does not depend on interest rates as the relation is negative and weak. Central banks does not need to change the interest rates in order to stabilize the inflation rate as it can be controlled effectively by other parameters.

Conclusion

The paper has effectively studied the dependence of central bank with respect to the inflation rate. Studies has effectively revealed how bank policies regarding the interest rates are effectively dependent in the inflation rates. The rate of inflation effectively acknowledges the way to change the interest rate and balance the money supply in order the change the aggregate demand for goods and services. On the contrary, many experts revealed that central banks does not effectively depend on inflation rates to control the money supply in the economy and rate of inflation. It depends on other parameters or indicators like exchange rates, cash deposit rates, unemployment rates. The data analysis has been conducted by using secondary data by using secondary quantitative techniques with the usage of statistical methods like correlation statistics and regression statistics. The analysis shows a negative correlation with the independence of central banks to target lower inflation rate with respect to monetary policy that changes the interest rate. The value is neither strong nor good which establishes the fact that the independence of central bank as a way of influencing lower inflation rate cannot be achieved by changing interest rate.

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