what happens when the central bank increases bank rate in an economy

1. Analyze the question The question asks about the effect of a rise in the bank rate (the rate at which the central bank, the CBN in Nigeria, lends to commercial banks) on the economy.

2. Explain the concept The bank rate is a monetary policy tool. When the central bank raises it:

• Borrowing from the central bank becomes more expensive for commercial banks.
• Commercial banks pass this cost on by raising their own lending rates.
• Loans become costlier for businesses and individuals.
• Less borrowing means less credit creation, so the money supply falls.

This is called contractionary (tight) monetary policy, and it is used to control inflation.

3. Step-by-step solution

• Bank rate rises, so the cost of funds for commercial banks rises.
• Commercial lending rates rise.
• Customers are discouraged from borrowing.
• Credit and money supply shrink.

Checking the options:

• A. Borrowing is discouraged: Correct. Higher interest rates make loans more expensive.
• B. Customers increase their borrowing: Wrong. This would happen if the rate were reduced.
• C. Banks can increase their lending: Wrong. Banks lend less, since funds cost more.
• D. Money supply increases: Wrong. Money supply decreases. Increasing it would need a lower bank rate.

4. Answer The correct option is A. borrowing is discouraged.

5. Exam tip Remember: "Rate up, borrowing down, money supply down." A higher bank rate always works in the opposite direction from a lower one, which encourages borrowing and expands the money supply. Whenever you see "increase in bank rate," think tight money, fighting inflation.