The price that a lender demands from a borrower for the use of borrowed money is the interest rate. Interest is an opportunity cost to the lender and a cost of capital to the borrower. Higher interest is paid if the borrowing is for an extended period. The supply of and demand for money typically determines interest rates. High demand for funds leads to a rise in interest rates and the converse is true. Monetary authorities in various countries, however, influence the rates of interest by managing the liquidity levels in the economy. This paper briefly examines some of the key factors that currently affect the interest rates and highlights new stories relating to these factors.
During inflationary periods, money loses the purchasing power in which case a unit of a currency purchases progressively fewer goods. Inflation results when the growth rate of the money supply is faster than the output of both goods and services. The consumer price index is the standard measure of inflation. The index shows the variations in prices for a fixed set of consumer goods and services for every month (Bureau of Labor and Statistics, 2017). During inflationary periods, banks will charge higher interest rates to safeguard their funds against the adverse impact of the rising inflation. Lenders are aware that if they lend out money during inflation the purchasing power of the same amount will be less when repaid. Consequently, they will demand higher rate known as the inflationary premium (Gwartney, Stroup, Sobel, & Macpherson, 2015, p.187).
Another factor that strongly affects the interest rates is the level of economic activity in a country. A growing economy means its citizens have jobs from which they earn salaries part of which they save in banks and other financial institutions who eventually lend out. Others borrow to finance the purchase of homes, cars, and businesses. When the economy grows, demand for funds goes up putting an upwards pressure on interest rates which act as a ration for the available funds. Interest rates subsequently fall when the demand for the money decline. The Fed recently raised the interest rates a sign of confidence in the U.S. economy. However, this will have an impact on borrowers due to the increase in the cost of lending (Washington Post, 2017).
Figure 1. Inflation, interest rates and economic growth in the US 2012-2016.
Through the effects of increasing or reducing the money supply in an economy, central banks affect the interest rate through the monetary policy framework. Interest rates fall through the loosening of the monetary policy since the action increases money supply or liquidity levels in the economy. The fall in interest rates spurs economic growth but simultaneously leads to higher inflation. However, an action of tightening the monetary policy leads to a rise in interest rates hence adversely affecting economic growth. Recently the Central Bank of China increased the repo rates to tighten its monetary policy leading to declining interbank financing and issuance of bonds (Investing.com, 2017)
Interest rates are a significant factor that determines the money that lenders earn from lending and borrowers pay for the money. Thus it is important to comprehend how the interest rates change. The forces of demand and supply primarily affect interest rates. As the economy grows, the demand for money puts upward pressure on the interest rates while low growth leads to a decline. Interest rates will increase during inflationary periods and fall when inflation level drops. The government applies the monetary policy to increase or reduce the amount of money in circulation. Loose policy increases flow of money thus the interest rates fall while tight policy reduces supply thus the rising of interest rates.
Bureau of Labor and Statistics. (2017). Consumer price index. Retrieved from https://www.bls.gov/cpi/
Gwartney, J. A., Stroup, R. L., Sobel, R. S., & Macpherson, D. A. (2015). An introduction to basic macroeconomic markets. In Economics private and public choice (15th ed., p. 187). Stamford: Cengage Learning.
Investing.com. (2017). China: monetary policy tightening has begun. Retrieved from https://www.investing.com/analysis/china:-monetary-policy-tightening-has-begun-200196494
The Washington Post. (2017). Fed raises interest rate, signaling confidence in the economy. Retrieved from https://www.washingtonpost.com/news/wonk/wp/2017/06/14/fed-raises-interest-rate-signaling-confidence-in-the-economy/?utm_term=.309c732fda56
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