Interest rates refer to the cost of borrowing money or the return on saving money, expressed as a percentage of the principal over a specific period, usually annually.

In many economies, the central bank plays a crucial role in influencing these rates. For instance, the central bank can set a benchmark short-term interest rate, such as the Federal Funds Rate in the United States or the Bank Rate in the UK, which then impacts rates throughout the financial system.

By adjusting this key rate, the central bank aims to influence the level of economic activity:

• When the central bank raises interest rates, borrowing becomes more expensive, and saving becomes more attractive. This typically leads to a decrease in consumer spending and business investment, which can help to control inflation by reducing aggregate demand.
• Conversely, when the central bank lowers interest rates, borrowing becomes cheaper, and saving offers a lower return. This is intended to encourage increased borrowing and spending by firms and households, thereby stimulating economic growth and employment.