Among other things that influence interest rates, monetary policy is also one of them. Democratic governments use two policy tools to help their economies thrive. There is the fiscal policy and monetary policy.
First, let us discuss the difference of fiscal policy to monetary policy. Fiscal policy pertains to the power of the government with congresses or parliament’s consent to increase or decrease tax rates. To increase tax rates, would mean to take away the disposable income of civilians. Think of it this way, the economy is a wheel. The movement of money makes the wheel turn. When people spend less money, the economy turns slowly. So the government increases taxation. The extra money the government collects is then spent on projects that will pour money back into companies for government mandated projects. These companies in turn will give them back to the people by employing more employees or by paying their existing ones with more. Such spending is also known as “pump-priming” activities.
Another instrument of fiscal policy would be for the government to borrow money for its expenditures. They do this so as not to over tax their citizens and provoke protest actions against their management. However, borrowing is not always an option. Lenders do not easily part with their funds. The general economic environment is placed into consideration.
But enough about fiscal policy, we are here to discuss the influence of monetary policy on interest rates. Now, bearing in mind that the economy is a wheel with money as the gas, monetary policy is the power of the government to control the flow of money in its society. When interest rates are high, the tendency of people is to control their spending and as much as possible stay away from borrowing money. This in turn slows down the movement of money in society. So one strategy the government employs is to lower down the interest rates, to attract people to borrow money and spend them on projects or businesses. Who among us would not suddenly think of purchasing houses, cars or expansion of current businesses when very low interest rates prevail? Such interest rates would make you think your money will earn more by investing it where yields are higher. When the economy is in danger of overheating (when growth is too fast, threatening a rise in inflation), the government increases interest rates to make access to excess money more expensive and arrest spending. Normally, such policies are implemented by a central bank that has more influence with creditors such as banks and other financial institutions.
The main reason that governments undertake such measures is to spur or to impede the economic growth through introduction of the monetary policy. Interest rates become a tool to help manage the economy.
In effect, the monetary policy can be gleaned to be tied up with interest rates. However, just as stated earlier, there are a lot of macroeconomic factors that affect interest rates. Inflation, supply and demand for money and other general economic indicators are normally related to one another, which in turn dictates which interest rate to peg.