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Interest Rates Explained

Lending money for free does not make sense. Alex may want to borrow $10,000 from Bob, but Bob will need to be given a financial incentive in order to loan her the money. An incentive is provided here in the form of interest, which is a sort of fee that is added on top of the amount Alice borrows. Interest rates have a profound impact on the broader economy as they dramatically affect people's behavior when they are raised or lowered.

When interest rates are higher, saving money becomes more attractive since banks offer a higher interest rate for the money you are storing with them. Since borrowing money is less attractive because you need to pay higher amounts for the credit that you take out, borrowing money is less attractive.

Low interest rates make it more attractive for people to borrow and spend money - money not used makes little profit if it sits idle. Further, you don't have to pay huge amounts over and above what you borrow.

Introduction

As explained in How Does the Economy Work? Credit plays a crucial role in global economic activity. In essence, it's a financial transaction lubricant. Individuals can leverage capital that they don't have and then they can repay the loan at a later time. Businesses can take advantage of credit to purchase resources in order to turn a profit, and then pay the lender for the resources they used. You are able to borrow money to purchase goods, and you can then repay the loan in smaller installments over time.

A lender needs to be incentivised by a financial incentive in the first place to offer credit in the first place if they are going to do so. Most often, they will charge an interest rate. Here we'll take a look at the current interest rate and how they work in this article.

What is an interest rate?

A loan with interest is one in which a borrower owes money to the lender. When Alex borrows $10,000 from Bob, Bob may tell Alex that you can have this $10,000, but that there will be 5% interest on it. Therefore, alex will need to pay back her original $10,000 (principal) plus 5% of that amount by the end of the time period that she has to pay it back. Therefore, the total amount Alex will repay to Bob is $10,500.

A percentage rate is a measure of how much interest is owed to the lender per period. Alex would owe $10,500 in the first year if she were to pay 5% per year on the loan. Then, you might have:

An interest rate of 5% per year is charged in subsequent years
The interest rate is compounded - 5% of the $10,500 in the first year, then 5% of the $10,500 + $525 = $11,025 in the second year, etc.

Why are interest rates important?

As with most people, unless you only deal in cryptocurrencies, cash, and gold coins, interest rates affect you as well. Dogecoins play a significant role in the overall economy, so even if you were able to pay for everything with them, you would still feel the impact of their effects.

Take commercial banks for example - their entire business model (fractional reserve banking) revolves around borrowing and lending money to each other. The moment you deposit money, you are acting as a lender. Since the bank borrows your money to lend to other borrowers, you receive interest from the bank. When you borrow money, on the other hand, you pay the bank interest.

As far as setting interest rates are concerned, commercial banks do not have much choice - that is left to entities called central banks. Take for example the US Federal Reserve, the People's Bank of China or the Bank of England. Their job is to make sure that the economy remains healthy by fiddling with it. Raising or lowering interest rates is just one function they perform to this end.

You will receive more interest for lending your money if interest rates are high. The flip side of this is that it would be more expensive for you to borrow, as you would have to pay more interest. During low-interest rates, it is not profitable to lend, but it becomes attractive to borrow when interest rates are low.

As a result of these measures, consumers' behavior can be influenced. It is common to lower interest rates in times when sales have slowed, in order to stimulate spending, as it gives individuals and businesses a reason to borrow. As soon as they have more credit available to them, they will hopefully go ahead and use it.

While it might be a good thing in the short-term to stimulate the economy by lowering interest rates, it also causes inflation. The amount of credit available is greater, but the amount of resources remains the same. The demand for goods is increasing, but the supply does not keep up with the demand. As a result, prices gradually rise until an equilibrium is reached.

In such a case, high interest rates could serve as the counter-measure. The higher the interest rates are, the lower the amount of credit available since everyone pays off their debts. Banks offer generous interest rates at this point, causing individuals to decide to save their money instead of spending it. Inflation decreases due to the decrease in demand for goods, but economic growth slows as a result.

What is a negative interest rate?

Most economists and pundits often refer to negative interest rates when they talk about the economy. It is important to note that these are sub-zero rates at which you must pay to lend money - or even to store it at a bank. The result is that banks find it very costly to lend. It makes it even more costly for individuals to save.

This may appear absurd. Ultimately, it is the lender who assumes the risk that the borrower will fail to repay the loan. Why should the lender pay?

This is perhaps one of the reasons why negative interest rates are treated as a last resort to fix struggling economies. The idea originated from a fear that people may choose to hold onto their money during an economic downturn, preferring to wait until things start looking up before engaging in any kind of economic activity.

It seems illogical to borrow and spend when interest rates are negative. Borrowing and spending would be a more logical choice. The fact that negative interest rates are considered a valid measure under exceptional economic conditions, has therefore led some people to consider them as a valid measure.