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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.
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:
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.
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.
We usually use two theories to help us calculate interest rates:
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.
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.
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:
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.
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%.
Interest rates aren’t static but change in response to other external forces. Three major determinants of the interest rates are:
The shift in interest rates can influence the spending patterns, inflation rate, and capital market.
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 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 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.
1. Joydeb Sarkhel, Macroeconomic Theory, 1995.
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.
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