Interest Rate Policy

Money & Banking · Advanced

Central banks can set any interest rate they choose - they don't have to follow 'market rates.' The natural rate is zero because the government can create money at no cost. When rates are higher, it's a policy choice that adds income to bondholders and increases costs for borrowers like homebuilders.

Money & Banking · Fundamental

The central bank's ability to set interest rates as a policy choice rather than being constrained by market forces, with zero being the natural rate for sovereign currency issuers since money creation has no inherent cost.

Showing the general audience (curious adults) level. Rewrites in place at every other depth.

Interest rate policy refers to how central banks set the benchmark interest rates that influence borrowing costs throughout the economy. Traditional economics suggests these rates are determined by supply and demand for money, but MMT reveals a different reality: sovereign governments that issue their own currency are price-setters, not price-takers, in financial markets. The central bank sets the overnight rate, and all other rates in the economy adjust relative to this anchor. When rates are low, borrowing is cheaper, encouraging spending and investment. When rates are high, borrowing becomes more expensive, typically slowing economic activity. However, MMT economists note that higher rates can also increase income for savers and bondholders, creating complex effects on aggregate demand.

Why it matters

This understanding fundamentally changes how we view government power over the economy. Rather than being at the mercy of financial markets, governments can actively choose interest rate levels to achieve policy goals. This means unemployment and economic downturns aren't inevitable market outcomes but policy choices.

Example / analogy

Consider the Federal Reserve's response to COVID-19: they immediately cut rates to near zero and kept them there. This wasn't because markets forced them to, but because they chose this policy to support the economy during crisis.

Detailed explanation

Unlike private entities that must borrow at market rates, currency-issuing governments face no financial constraints when setting interest rates. The central bank can maintain any rate it chooses, including zero permanently (ZIRP). Higher rates represent a policy choice to provide income to bondholders while increasing costs throughout the economy - from homebuilders who must carry inventory costs to businesses financing operations. This challenges mainstream views that interest rates must be set by 'market forces' or that there's a 'natural rate' determined by economic fundamentals. MMT shows that for sovereign currency issuers, zero is the natural rate since money creation costs nothing.

Common objections

"Higher interest rates are needed to control inflation" - MMT shows fiscal policy is more effective for managing aggregate demand, while rate hikes mainly redistribute income to bondholders.
"Markets determine interest rates through supply and demand" - Central banks set the overnight rate by fiat, and longer rates follow this administered rate plus term premiums.
"Zero rates would cause runaway inflation" - Japan maintained near-zero rates for decades without hyperinflation, showing rates don't directly control price levels.

Editorial history →

Governance

Reviewed by: Not yet reviewed
Confidence: Medium
Version: 1
Layer: Fundamental

Cite this concept

https://knowledge.sovereigneconomics.org/concepts/interest-rate-policy/

BibTeX

@misc{sef-concept-interest-rate-policy-2026,
  author = {Sovereign Economics Foundation},
  title  = {Interest Rate Policy},
  year   = {2026},
  note   = {Version 1, accessed 2026-07-18},
  url    = {https://knowledge.sovereigneconomics.org/concepts/interest-rate-policy/}
}

AP / Chicago note

Sovereign Economics Foundation. (2026). "Interest Rate Policy." SEF Knowledge Graph (v1). Retrieved 18 July 2026 from https://knowledge.sovereigneconomics.org/concepts/interest-rate-policy/.

HTML hyperlink

<a href="https://knowledge.sovereigneconomics.org/concepts/interest-rate-policy/">Interest Rate Policy</a> · SEF Knowledge Graph

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