Interest rates that are determined by the free market, rather than a governmental body, are called open market rates. In the free market, interest rates will respond directly to factors such as supply and demand. This contrasts with interest rates set by a central bank. Open market rates can fluctuate widely if not stabilized by a governmental body. Central banking systems can manipulate interest rates in a variety of ways.
Most countries have some positive level of inflation in the value of money. This means that a given amount of money will buy fewer goods and services in the future. This devaluation of money is one reason lenders charge interest rates on money lent. If the same amount of money was returned by the borrower, it would buy fewer goods and services, and the lender would be worse off. An annual percentage of the money lent, therefore, is generally charged by lenders of money.
Historical experience has shown that unpredictable events can cause high levels of fluctuation in the free market. These fluctuations can affect free market interest rates as well as prices, which in turn impact the larger economy. When open market rates go up, businesses and banks that need to borrow money can run into difficulty. They may have based planning strategies on the availability of lower interest rates. Stabilizing interest rates, therefore, is one way to stabilize the larger economy.
This is where governmental monetary policy comes in. A central bank such as the United States Federal Reserve or the European Central Bank can lend money directly to financial institutions. The interest rate charged is often fixed and is called a discount rate. Central Banks can also manipulate open market rates by carrying out open market operations. In this technique, interest rates and the total money supply are controlled by indirect means.
Conducting the monetary policy of the U.S. is one of four main responsibilities of the Federal Reserve System. The Fed can lend money directly to financial institutions at lower rates than open market rates. This helps to keep employment at optimal levels and control prices and interest rates.
Without low-interest loans from a central banking institution, many businesses and financial institutions could fail in times of crisis. If these businesses are very large and interconnected, their failure could profoundly affect the larger economy. These businesses are sometimes referred to as “too big to fail.” Offering low-interest loans to select institutions is controversial, however. It can offer an incentive to take on additional risks that others will end up paying for.