What is a Key Rate?

Malcolm Tatum

The key rate is the interest rate that currently plays a major role in setting the lending rates used by banks and other lending institutions within a specific country. From this perspective, this means that the rate has a direct impact on what borrowers pay in order to have access to loans and other forms of credit. While each nation determines this key rate using criteria that is relevant to their economic structure, the end result for consumers is usually the same, in that this interest rate exerts a direct or indirect influence on the interest rates they are charged on mortgages, personal loans, and even on credit card balances.

In the United States, the Federal Reserve uses two key rates to set other interest rates nationally.
In the United States, the Federal Reserve uses two key rates to set other interest rates nationally.

In the United States, there are actually two different key interest rates that come into play when setting interest rates on various types of lending activity. One is the federal funds rate, and the other is known as the discount rate. Both rates are utilized by the nation’s Federal Reserve system, which means that most banks in the country will look closely at how the Federal Reserve makes use of those figures and adjust the rates of interest offered to consumers accordingly.

One of the effects of the key rate is that adjustment of this rate can have a profound effect on the economy. From this perspective, lowering or increasing either the federal funds rate or the discount rate can be a powerful tool when it comes to dealing with inflation, or when attempting to lift an economy out of a recession. In general, if the idea is to expand the money supply, the key rate is lowered slightly. This has the effect of decreasing the cost of borrowing funds for consumers, motivating them to spend now rather than later.

At the same time, if the idea is to place some limits on the money supply, this process can be initiated by increasing the key rate. As a result, consumers have to pay more in order to borrow money, a fact that may cause many to put off making major purchases that require financing, until the economy is more stable and interest rates drop back to a more acceptable level. Shifting the key rate is by no means capable of correcting an unfavorable situation within an economy on its own, but can be used in conjunction with other economic strategies to produce the desired effect over a period of time. It is not unusual for governments to implement a series of upward and downward shifts in one or both key rates over a period of several years, if projections of the movement of the economy merit this type of ongoing strategy.

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