The policy rate is the interest rate that the Bank of Albania sets as the target for its transactions with commercial banks. Simply put, is the rate that the central bank pays for commercial banks’ deposits or offer banks for short-term loans.
By changing the policy rate, the Bank affects all interest rates in the market, in order to create the conditions to guarantee the quantity of demand and supply of the economy for goods and services, balanced at a level that produces prices that are close to the Bank’s 3% inflation target.
So, an increase in the policy rate makes investments more costly and savings more profitable. This happens mainly when the Bank thinks that the economy is overheating - when it is moving faster than the equilibrium.
A decrease in the policy rate discourages spending, since the interest rates on deposits and loans decrease, boosting investments and spending. This happens when the Bank thinks that the economy is moving slower than the equilibrium.
This happens for several reasons. First, the commercial bank are free to set the interest rate without direct constrains by the Bank of Albania. The interest rate they offer for loans is exclusive to their business policies and models. The rate of the Bank of Albania is the rate by which the central bank offers funds to the banks. The Bank of Albania sets this rate keeping in mind price stability, which is its primary target. However, when the Bank of Albania lowers the policy rate, it lowers the cost of one of the sources of funds for the commercial banks. Competition in the banking sector will make so that the interest rates of loans to households or enterprises will decrease as well.
Second, the monetary policy does not have an immediate impact on the financial market. It needs 1-3 years to be transmitted completely. Changes in the interest rate today will continue to affect interest rates in the economy for several quarters. If you have had a loan for a long time, you may have noticed that interest payments you make today are lower than a few years ago, since the Bank of Albania started to implement an accommodative monetary policy, thus lowering the policy rate. The interest rates on deposits follow the same trend as well.