Interest rates are the cost of borrowing money. From a different perspective, it is the reward that a lender gets for risking his money. It keeps the economy moving by encouraging people to lend, to borrow, and to spend. Here are the biggest factors that affect interest rates.
Borrowers and Lenders
The money lender takes a risk that the borrower may not pay back the loan. Therefore, interest provides a certain compensation for bearing the risk. Partnered with the risk of default is the risk of inflation. When you lend the money now, the prices of goods and services may go up by the time you are paid back and so your money’s original buying power would decrease. Therefore, interest protects against future hikes in inflation. A money lender like a bank uses the interest to process account costs as well.
Borrowers pay interest because they must pay a price for gaining the ability to spend now, rather than having to wait years to save up enough money. For instance, a person or a family may take out a mortgage for a house for which they cannot at present pay in full, but the loan lets them become the owner of the house now instead of far into the future.
Supply and Demand
Interest rate levels are a factor of supply and demand of credit: an increase in the demand for money or credit will push interest rates up, while decreases in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.
The supply of credit is increased by an increase in the amount of money made available to the borrowers. For instance, suppose you open a bank account. You are in fact lending money to the bank. Depending on the kind of account you open, the bank can use that money for its business and investment activities. In other words, the bank can lend out the money to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the price of the borrowing, or interest, decreases.
Inflation will also affect interest rates and their levels. Higher inflation rate means higher possibility that interest rates will rise. This happens because lenders will demand higher interest rates as compensation for the decrease in the purchasing power of the money they will be repaid in the future.
The government also has a say in how interest rates are affected. The US Federal Reserve, or simply the Fed, often makes announcements about how monetary policy will affect interest rates.
The federal funds rate, or the rate that institutions charge each other for extremely short term loans, affects the interest rates that banks set on the money that they lend. That rate then eventually trickles down into other short term lending rates. The Fed influences these rates with “open market transactions,” which is basically the buying or selling of previously issued US securities.
When the government buys more securities, banks are given with more money than they can use for lending, and the interest rates decrease.
When the government sells securities, money from the banks is drained for the transaction, rendering fewer fund at the banks’ disposal for lending, forcing a rise in interest rates.
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