Interest rates, in simple words, represent the cost of borrowing funds or money. Interest rates represent what creditors or lenders, such as banks and credit unions, earn for lending you funds. You may know what an interest rate is, especially if you are paying off your mortgage or relying on the interest income from savings. Interest rates are a regularly changing part of our modern economy. As there are so many aspects of global finances that depend on the rate of interest, it is easy for people to get confused and to start thinking of interest rates as a magical and mysterious force.
You may think that interest rates would increase during an economic recession; however, the opposite is true. It is worth noting that federal interest rates increase when the economy is booming. On the other hand, the Federal Reserve adjusts the interest rates during a recession in an effort to stimulate the economy.
You would want to understand exactly how to calculate the interest income you will receive when you keep your money on deposit for a specific period of time. That being said, it is also good to know about how financial institutions, such as central banks, arrive at the interest rates that they advertise.
It goes without saying that as with any service or good in a free market economy, ultimately price boils down to demand and supply. And prevailing interest rates are often fluctuating, and different kinds of loans offer slightly different interest rates. If you’re a borrower, lender, or both, it is vital to understand the various reasons for these changes as well as differences. Lenders usually charge less interest to part with their funds when demand is weak; on the other hand, when demand is strong, they can increase the fee, also known as the interest rate.
One of the best ways to think of market interest rates is as the “cost of money.” If you want to spend more than the actual cash you have on hand, you’ll have to find someone to lend your those additional funds. Note that the lender will consider the benefits of retaining his funds for his own spending or investing them. Usually, when times are tough, people and businesses are not too interested in borrowing money. Hence, the US Federal Reserve tends to lower interest rates in order to encourage individuals to spend more money. Also, both the borrower and lender consider the interest payment on the amount of loan in percentage terms. A $10 interest payment on a loan of $100 that’s outstanding for a year is known as a 10% interest rate (10 divided by 100).
The interest rate that your lender charges you reflect the extent of risk that you may default on your loan. It is worth noting that the rise and decline of interest rates are often very difficult and tricky to predict. Interest rates change because of and are reflected through monetary policy, economic growth, and fiscal policy.
As mentioned above, interest rate levels in an economy are often a factor of the demand and supply of credit. You should note that a rise in the demand for credit or money will increase interest rates. In contrast, a decline in the demand for money will decrease interest rates. The demand and availability of money drive interest rates in a pure free market.
Individuals and businesses borrow money from banks, and banks borrow money from other banks, credit unions, financial institutions, and, often, from the government. Note that an increase in the sum of money available to borrowers will increase the supply of credit. Consider a simple example. When you open a bank account with a local bank, you’re lending money to that bank. Depending on the type of account (such as current account) you open, the bank or financial institution will use these funds for its business and/or investment activities.
For example, usually, a certificate of deposit will yield a higher interest rate compared to a checking account, as you can always access the funds with a checking account.
Note that the more banks and financial institutions can lend, the more money is available to the economy. When the supply of credit in the market increases, the cost of borrowing decreases. We can say that our whole financial system is predicated on the notion that borrowers pay a certain percentage, called the interest rate, for borrowing money. So, when borrowers are coming out of the woodwork the demand will be high. In this case, expect interest rates to increase as fund availability is low and your bank or credit union will have to borrow funds from another bank or government in order to continue extending loans.
Inflation tends to devalue both money and purchasing power. This is why it can have a considerable effect on market interest rates. Keep in mind that the higher the rate of inflation, the more interest rates will likely rise. Lenders are aware of the fact that inflation erodes the value of their funds over the time period of a loan, and this is why they increase interest rates as it helps compensate for the loss.
Under a modern system called fractional-reserve banking, inflation and interest rates are inversely correlated. Note that this relationship usually is one of the key tenets of modern monetary policy: a central bank in a country manipulates short-term interest rates in order to affect the inflation rate in the economy.
When lenders determine the interest rates to charge their borrowers, they always factor in or take into account their estimates of what price levels will be in the future in order to ensure that lenders will profit from their loan.
Interest rates and inflation are directly proportional because lenders are likely to demand a higher interest rate as compensation for the decline in purchasing power of the funds they are repaid in the future.
It is no secret that when inflation is high, lenders will not usually loan funds for anything except extremely short term unless there’s a considerably higher interest rate attached – the 1970s were an excellent example, particularly during the Carter years. Investors like preserving their “purchasing power,” so when inflation is high with higher risks, they’ll need a considerably higher interest rate in order to consider lending funds for more than the shortest of terms.
Monetary policy is another important factor that affects interest rates in an economy. The Federal Open Market Committee meets 8 times in a year to review financial and economic conditions and decide on its monetary policy. We can say that monetary policy refers to the various actions taken that impact the cost and availability of money and credit.
Most governments like to affect the direction of interest rates. They achieve this by actions that tend to either inflate or deflate the cost of borrowing in an economy. One of the main methods of doing this is via printing money. Note that central banks in a country alter the money supply in order to manage the economy as well as control inflation.
When a government loosens its monetary policy, it means that the government has “created more money.” So, a central bank, such as the Federal Reserve, will literally create more money by depositing the funds into its accounts at various commercial banks. Keep in mind that this will makes interest rates lower since more money is available to both lenders and borrowers in the market.
A commonly used term is “loosening monetary policy” or fiscal policy. This means that a government has chosen to print more money to bring interest rates down in the country. This is intended to encourage more borrowing in an economy and provide a much-needed spark to the economy. Sometimes this works. Sometimes it does not. On the other hand, if the supply of funds is lowered by withdrawing money from banks, this is known as the tightening of the monetary policy, which causes interest rates to increase.
This is another important variable. When it comes to debt, the bond market is considered the law of the land. Bond prices tend to rise when interest rates fall in an economy, and bond prices decline when interest rates increase.
When a country issues more debt in the name of its government, it usually has to create more money in order to offset the debt. Note that this helps expand the money supply, and this, in turn, drives up interest rates as a matter of economic policy. Keep in mind that when the market is hungry to purchase the bonds that the government has issued this raises the money supply. On the other hand, when the market is less interested in buying, the money supply either stagnates or decreases, which pressures interest rates to go downwards.
Interest rates, inflation expectations, bond yields (prices) often correlate with one another. Movements in interest rates (short-term), as determined by a country’s central bank, will impact different bonds with varying terms to maturity differently. Interest rates are affected by the supply and demand of money, inflation level, and economic growth in a country. While interest rates are a bit complicated, they are fairly simple to understand when you know and understand all the forces behind them.