It’s a widely accepted notion that if a central bank puts up interest rates it has a negative effect on the amount borrowed and on borrowers. This is why in a period of poor economic growth interest rates are floored so as to encourage borrowing and thus improve demand. Interest rates only go up once economic growth is at desired levels.

However, interest rate can also play a positive role in the extension of credit, especially under tight credit conditions. It may sound counter intuitive to increase interest rates when there is weak economic conditions as it could damage the economy, but it encourages savings and attracts investors. In the short term, it would deter borrowing and hit the pocket of borrowers, especially those with tracker mortgages. But it would also extend borrowing as increased deposits buoy the balance sheets of banks and more can be borrowed on the international markets for domestic borrowers.

At a time when credit is tight, it needs to be loosened. This act should loosen the credit supply and with the money supply tightened, it should also negate any inflationary effect of a credit expansion.

Advertisements