Central banks use its own policy on interest rates to control inflation and the national currency. The European Central Bank, the Federal Reserve, the Bank of England and the Bank of Japan, as well as all other central banks, set their own interest rates, which provides loans to the financial markets. The interest rate of the central bank affects all domestic interest rates set by construction companies, commercial banks and other financial institutions, as well as on the prices of government bonds, stocks and, of course, the exchange rates, especially the national currency. Established by the Central Bank, the basic exchange rate is reflected in the markets and, ultimately, to the consumer, significantly affecting the way consumers and businesses spend their money. The central banks decisions to regulate interest rates have a direct impact on the economy.
By raising interest rates, the central bank creates the conditions in which to borrow money is unprofitable and expensive as fees on loans are increasing. At the same time, interest rates on deposits become more attractive, and more and more people are starting to save money. However, higher interest rates attract investors, and strengthening the national currency against foreign currencies, as investors buy its assets to invest in the country. With the strengthening of the exchange rate the import is cheaper and exports are more expensive, which leads to deflation in the economy. Rising borrowing costs and exchange rates could lead to higher inflation and cost of goods and services.
Conversely, a decrease in interest rates has the opposite effect, because the borrowing costs are low, the stock prices are raising along with the property prices. When investors move their money in countries with higher interest rates, the exchange rate weakens. This increases the welfare of consumers and the export goods and services become more competitive. But the increase in consumer spending and exports has an inflationary effect on the economy and could force the central bank to raise interest rates again.
Interest rates and inflation:
The nature of consumer spending is reflected in the volume of production and employment. This affects the supply and demand of the working population due to changes in the cost of wages. It also affects the inflation forecasts of people claiming the salaries and is reflected in costs and prices. All the effects occur at different rates, and the delayed effect of interest rate changes on the spending and savings, as well as on the exchange rate, is evident. Therefore, interest rates vary based on inflation forecasts rather than current inflation and the exchange rates which follow it.