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.

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.

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.

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 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.

Liquidity preference theory

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

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.

Nominal interest rate vs real interest rate

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

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

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.

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.

Reference

1. Joydeb Sarkhel, Macroeconomic Theory, 1995.