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Bank Interest Rates

Bank Interest Rates

In the same way you tip waiters or waitresses at a restaurant, interest is the extra money that comes with trading a financial asset. Depending on who you are (a seller or a buyer of financial assets), interest can come as a reward or a cost for lending/receiving the money. Let’s dive deeper into the concept of interest rates and their influences on the market.

What are bank interest rates?

Interest rates are the reward for lending and the cost of borrowing money. It’s a percentage paid for your investment in a loan.

Here’s the formula to calculate a simple interest rate:

In which:

  • I: Simple interest rate.
  • P: The amount of money invested or borrowed.
  • r: Annual interest rate.
  • t: The time you invest or borrow the money for.

The cost of borrowing £1000 at a 5% annual interest rate is £50 per year.

The reward for investing £1000 at a 2% annual interest rate is £20 per year.

How are interest rates determined by the supply and demand of credit?

Interest rates can go up or down depending on the supply and demand of credit. The increase in credit demand will cause the interest rates to rise, while a fall in credit demand will result in a drop in the interest rates. Similarly, an increase in the credit supply will reduce the interest rates, whereas a decrease in credit supply will increase them.

The supply of credit comes mostly from your private savings. This is the money you put in a bank which will then be lent out to those in need. For example, a business raising capital to expand its operations or fund new projects.

The amount of credit in the economy relies on the banks’ ability to lend. The more credit banks can lend, the higher the credit supply. With more credit available, the cost of borrowing (interest rates) decreases and more people will borrow money to spend. However, there’s a chance that borrowers don’t pay their loans which results in a shortage of credit in the economy. In this case, the credit available is lacking and the reward for lending (interest rates) will increase.

How to calculate interest rates?

We usually use two theories to help us calculate interest rates:

  • Loanable Funds’ Theory.
  • Liquidity Preference Theory.

Both theories determine the interest rate based on the demand and supply of credit. The difference is that while the Loanable Funds’ Theory considers all types of credit, the Liquidity Preference Theory only considers the most liquid credit.

Loanable funds’ theory

The loanable funds’ theory states that the interest rate is determined by the demand and supply of loanable funds, including loans, bonds, or saving deposits.

The loanable funds’ theory differs from the classical theory in that it takes into account bank credit.

Bank credit is credit created by banks every time someone makes a loan. This is the ‘additional credit’ to the deposits that you and I put in the bank.

As a result, the equilibrium-market interest rate is determined by both the public propensities to save and the bank’s creation of credit and fiat money.

Fiat money: government-issued currencies. It excludes commodities such as gold.

Liquidity preference theory

The liquidity preference theory, proposed by John Maynard Keynes, determines the interest rate based on the demand for liquidity.

According to Keynes, the interest rate is the reward for one individual’s

parting with liquidity rather than his savings or investment.¹

To put it simply, when the money demand is high, it is not because a lot of people want to borrow money, but because the investors wish to remain liquid (hold cash rather than invest in financial assets).

Here are the three motives for people to hold cash:

  • The transaction motive: people prefer to keep liquidity to perform basic transactions such as shopping or buying food.
  • The precautionary motive: retaining liquidity can add protection against unexpected problems.
  • The speculative motive: people keep cash for fear of missing out on a good opportunity to invest in the future.

In the liquidity preference theory, cash is the preferable asset because people can cash it out in full value instantaneously. A piece of real estate, on the other hand, is an illiquid asset since it can take months to sell.

Nominal interest rate vs real interest rate

One thing to note when referring to interest rates is that they can be nominal or real.

Nominal interest rates are the interest rate that excludes inflation, whereas real interest rates account for inflation when determining the cost of borrowing.

To approximately calculate the real interest rate simply subtract the inflation rate from the nominal interest rate.

A person takes out a loan of 10,000 at an advertised rate of interest of 5% (nominal interest rate). Assuming the inflation rate is 2%, the real interest rate that borrower has to pay is 5% - 2% = 3%.

What are the determinants of interest rates?

Interest rates aren’t static but change in response to other external forces. Three major determinants of the interest rates are:

  • Supply and demand of credit: the interest rate can go up or down depending on the demand and supply of credit in the market.
  • The inflation rate: high inflation rates can result in a higher interest rate as lenders will need more money to compensate for their loss of purchasing power.
  • Interest rates set by Central banks: the central bank can set short-term nominal interest rates to spur economic activities. For example, it may reduce the interest rate to encourage people to borrow and spend more.

How do changes in interest rates affect the market? >

The shift in interest rates can influence the spending patterns, inflation rate, and capital market.

Spending

Interest rates not only give borrowers easy access to money but also influence the way they spend money.

With a lower interest rate, people are more likely to borrow money to purchase highly valuable items such as houses and cars. Businesses can also purchase more equipment which contributes to higher output and productivity.

By contrast, a high-interest rate can deter people from borrowing and spending. Consumers will cut back on consumption, which reduces the overall spending of the economy. Meanwhile, productivity and output will drop as businesses invest less in their facilities and equipment.

Inflation

Inflation is the rise in the price of goods and services over time, which indicates a strong economy. However, a substantial price increase, (e.g. hyperinflation), can result in a drastic loss of consumers’ purchasing power.

To reduce inflation, the Central Bank can raise the interbank rates: the interest rates that banks lend to one another. This will cause the market interest rate to rise and induce people to spend less. As the demand for goods and services drops, the prices will drop and cause the inflation rate to fall.

The capital market

The Capital Market is made up of bonds and shares (stock). The change in interest rates has a strong impact on the psychology of participants in the capital market.

For example, when the interest rate is high, people will want to reduce their spending, which causes the stock prices to drop. However, as soon as the interest rate drops, they will invest more which results in an increase in stock prices.

Interest rates also have an inverse relationship with bond prices. This means the rise in interest rates will decrease the bond price and vice versa.

To learn more about the inverse relationship between bond price and interest rates, check out our explanation on Capital markets.

Banking and Interest Rates - Key takeaways

  • Interest rate is the reward for lending or the cost of borrowing credit in an economy.
  • The interest rate can be determined by the demand and supply of credit in the market.
  • Two approaches to calculating the interest rate are the Loanable Funds Theory and Liquidity Preference Theory.
  • The real interest rate is different from the nominal interest in that it includes the inflation rate of the economy.
  • Three determinants of the interest rate include the supply and demand of credit, the central bank, and the inflation rate.
  • The change in the interest rate can influence individual and business spending, inflation, and the capital market.

Reference

1. Joydeb Sarkhel, Macroeconomic Theory, 1995.

Frequently Asked Questions about Bank Interest Rates

A higher interest rate means that banks can earn more money. Banks pay customers interest for depositing cash into the bank’s accounts but at the same time also invest the deposited money in short-term loans and collect interest. The difference between the bank deposit rate and the lending rate is the income that a bank receives. 


When the government increases the interest rate, banks can earn a higher interest on their invested money while the payout to customers remains the same, which increases their revenue. 

When the interest rates are low, people are more willing to borrow money to spend on large purchases such as a car or a house. This means banks can lend out more and increase their profitability. 


However, lower interest rates also mean that the lending rate may be lower than the bank deposit rate (banks can’t pay customers a negative rate), which reduces its profit margin and incurs a lower profit. Commercial banks tend to prefer higher interest rates. 

To reduce inflation, the Central Bank can raise the interbank rates which are the interest rates that banks lend to one another. This will cause the market interest rate to rise and discourage people from spending. As the demand for goods and services drops, the price will drop resulting in lower inflation.

Bank rate is the rate that the Central Bank charges the commercial banks for borrowing money, usually in the short term. Meanwhile, interest rate applies to any type of loan. For example, the bank pays a bank account holder 1% interest rate for their deposited money. 

Final Bank Interest Rates Quiz

Question

What are interest rates?

Show answer

Answer

Interest rates are the reward for lending and the cost of borrowing money. It's a percentage paid for your investment in a loan.  

Show question

Question

How does the supply and demand of credit influence the interest rate? 

Show answer

Answer

The increase in credit demand will cause the interest rates to rise while a fall in credit demand will result in a drop in the interest rates. Similarly, an increase in the credit supply will reduce the interest rates whereas a decrease in credit supply will increase them.

Show question

Question

What influences the amount of credit available in the economy?

Show answer

Answer

The banks’ ability to lend. The more credit banks can lend, the higher the credit supply. The supply of credit comes mostly from your private savings. 

Show question

Question

What happens when there's more credit available on the market?

Show answer

Answer

With more credit available, the cost of borrowing (interest rates) decreases, and more people will borrow money to spend. 

Show question

Question

What may cause the supply of credit in an economy to lessen? 

Show answer

Answer

Borrowers of loans issued by the bank may delay or default their payment, which causes a shortage of credit. 

Show question

Question

What are two theories for calculating interest rates?

Show answer

Answer

To calculate interest rates, two theories are in use: 

  • Loanable Funds' Theory.
  • Liquidity Preference Theory.

Show question

Question

What is the major difference between the Loanable funds' theory and Liquidity preference theory?

Show answer

Answer

The difference is that while the Loanable Funds' Theory considers all types of credit, the Liquidity Preference Theory only considers the most liquid credits. 

Show question

Question

What are loanable funds?

Show answer

Answer

All types of credit, including loans, bonds, or saving deposits.

Show question

Question

What is the Liquidity Preference Theory?

Show answer

Answer

The liquidity preference theory, proposed by John Maynard Keynes, determines the interest rate based on the demand for liquidity.

Show question

Question

According to the Liquidity Preference Theory, what results in the high demand for money (cash)?

Show answer

Answer

People's preference to hold cash as well as precautionary, or speculative motives. 

Show question

Question

What are nominal and real interest rates?

Show answer

Answer

Nominal interest rates are the interest rate that excludes inflation whereas real interest rates account for inflation when determining the cost of borrowing. 

Show question

Question

How do you calculate real interest rates?

Show answer

Answer

To approximately calculate the real interest rate simply subtract the inflation rate from the nominal interest rate.

Show question

Question

How is spending influenced by the shift of interest rates?

Show answer

Answer

With lower interest rates, people will borrow money to spend more while businesses purchase more equipment. This will increase the economy's spending and industry's productivity. High interest rates have the opposite effect. 

Show question

Question

What is inflation? When is inflation bad for the economy?

Show answer

Answer

Inflation is the rise in the price of goods and services over time, which indicates a strong economy. However, a substantial price increase, e.g. hyperinflation, can result in a drastic loss of consumers' purchasing power. 

Show question

Question

Loanable Funds’ Theory and Liquidity Preference Theory are used to calculate ___________ 

Show answer

Answer

interest rates

Show question

Question

The loanable fund's theory differs from the classical theory in that it takes into account the ___________.  

Show answer

Answer

bank credit

Show question

Question

Government-issued currencies are called ___________


Show answer

Answer

fiat money

Show question

Question

The three motives for people to hold cash are ___________, ___________, ___________

Show answer

Answer

  • transactional
  • precautionary
  • speculative

Show question

Question

In the liquidity preference theory, ___________ is the preferable asset because people can cash it out in full value instantaneously.

Show answer

Answer

cash

Show question

Question

What is the highest liquid asset?

Show answer

Answer

Cash

Show question

Question

A person takes out a loan of 10,000 at an advertised rate of interest of 5% (nominal interest rate). Assuming the inflation rate is 2%, what is the real interest rate that he has to pay?

Show answer

Answer

5% - 2% = 3%.

Show question

Question

With a ___________ interest rate, people are more likely to borrow money to purchase highly valuable items such as houses and cars

Show answer

Answer

lower

Show question

Question

Interest rates also have an inverse relationship with bond prices

Show answer

Answer

True

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