A:

In countries using a centralized banking model, interest rates are determined by the central bank.

In the first step of interest rate determination, the government's economic observers create a policy that helps ensure stable prices and liquidity for the country. This policy is routinely checked to ensure that the supply of money within the economy is neither too large (causing prices to increase) nor too small (causing prices to decrease).

Because retail banks are usually the first financial institutions to expose money to the economy, they are the principal instruments used by the central bank to manipulate the money supply. By adjusting the interest rates on the money it lends to or borrows from the retail banks, the central bank is able to regulate the supply of money to the end user (individuals and companies).

If the monetary policy makers wish to decrease the money supply, they will increase the interest rate, making it more attractive to deposit funds and reduce borrowing from the central bank. On the other hand, if the directors wish to increase the money supply, they will decrease the interest rate, which makes it more attractive to borrow and spend money. In the United States interest rates are determined by the Federal Open Market Committee, which consists of the seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.For more information, check out the The Federal Reserve (the Fed) Tutorial.

To find out more about interest rates, see Trying To Predict Interest Rates, Forces Behind Interest Rates and How Interest Rates Affect The Stock Market.

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