Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

earn a certain rate: Banks can guarantee a certain return if they deposit money. In the UK, the Bank of England calls this rate the bank rate.


Repurchase agreements: The central bank buys government bonds from a bank but at the same time enters into a contract to sell those bonds back to the bank in a week’s time at a slightly higher price. Think of it as the central bank lending money to the commercial bank at a certain interest rate (called the repo rate in the UK).


Deciding who can borrow at the base rate: Hint, it’s not you!

In 2009, the Bank of England reduced interest rates to 0.5 per cent. They’re still at that level as of 2015 and may stay that low for some time. The thing is, if you go to your local bank or building society and ask for a loan with an interest rate of 0.5 per cent, they’ll probably collapse in fits of laughter. Why can’t individuals and firms borrow at the official interest rate?

The interest rate set by the central bank is only available to commercial banks and not to private individuals or firms because the government hopes that an official low interest rate will encourage

commercial banks to lend at lower rates of interest. If the official interest rate is high, it increases borrowing costs for everyone else.

Commercial banks charge higher rates partly because they can, but also because costs are involved in assessing who should be lent money and who shouldn’t: that is, who’s likely to repay and who isn’t. Furthermore, when lending, commercial banks need to add a risk premium depending on how risky they think a borrower is. If a good chance exists that someone won’t repay a loan, banks are only willing to lend at a relatively high rate. On the other hand, someone seen as a ‘good risk’ usually gets a better rate.

Competition between commercial banks is meant to ensure that people don’t pay over the odds to borrow money and that any change in the central bank’s official interest rate filters through the financial system.