The rediscount rate is a fundamental monetary policy instrument. When the central bank raises this rate, it increases the cost for commercial banks to borrow money. This mechanism directly impacts the flow of base money in the financial system, creating a contractionary effect on money supply.
The rediscount rate is set by the central bank as a policy tool. This rate determines how much commercial banks must pay when they borrow funds from the central bank. When this rate increases, it becomes more expensive for banks to obtain liquidity, which affects their lending behavior.
There is an inverse relationship between borrowing costs and bank borrowing volume. As the rediscount rate rises, the cost of borrowing increases significantly. This higher cost discourages commercial banks from borrowing, leading to reduced demand for central bank funds and ultimately contracting the base money supply.
The base money contraction process is straightforward. When the rediscount rate increases, commercial banks reduce their borrowing from the central bank. This directly decreases the amount of new money entering the financial system. As less money flows from the central bank to commercial banks, the overall base money supply contracts, creating a tightening effect on monetary conditions.