Interest rates definition

The interest rate is the amount charged by a lender to the borrower for borrowing money. The interest rate is expressed as a percentage on an annual basis. Interest rates is one of the most important factors affecting a country’s economy and its financial markets.

Interest rate simple example

A simple loan is one in which the lender provides the borrower with an amount of funds called the principal that must be repaid to the lender at the maturity date along with an additional payment which is the loan’s interest rate.

Example: A loan has a principal value of $1,000, interest rate of 10% and a maturity date of one year. The interest paid at the end of year 1 is $1,000 x 0.1 = $100.

Interest Rates vs Money Market

The level of interest rate is determined by the demand and supply of money available in an economy. Interest rate is the cost of money. Low interest rates, make lending cheaper hence boost lending activity which in turn boosts economic activity and vice-versa.

When the supply of money is high compared to the demand for money, interest rates fall and vice versa.

Interest rates exist for all lending and borrowing transactions. The main financial instruments for lending transactions are loans and bonds.

The largest participant in the market for borrowing funds is the country’s government. The country issues government bonds to finance its operations. The second largest group of borrowers in a country are businesses. Small businesses borrow from commercial banks using loans and corporate bonds. The last group of borrowers are individuals which borrow funds to purchase homes, investment or consumption.

Interest Rate versus Risk

When a borrower is considered low risk, the lender will charge him a lower interest rate. When a country’s economy is healthy, it can finance its operations or investments by issuing government bonds with low interest rates. On the other hand, governments with weak economies either have a high chance on defaulting on their bonds or use monetary policy tools to print money in order to repay their loans with cheaper currency. Investors charge higher interest rates to compensate for the increased risk of not receiving money lent or receiving money with a lower value. The same holds for businesses and individuals. Riskier businesses and individuals are charged higher rates when compared to more creditworthy lenders. To reduce the risk of a loan and hence the interest charged, lenders often request a collateral from borrowers.

Real vs Nominal interest rates

The value of money is not constant. An economy experiences inflation which is the reduction in the value of money.

Lenders aim to maximize the return possible from the interest rate charged. However, they must take into account how much inflation has reduced the value of the money they receive back after the loan. Hence, lenders examine the real interest rate of a loan or a bond. Higher real interest rates incentivize them to lend funds and vice versa.

Nominal interest rate is the interest rate which does not take into account inflation. Real interest rate is the interest rate adjusted for inflation.

Real interest rate = Nominal interest rate – Expected inflation rate

Example: If nominal interest rate is 5% and the expected inflation is 2% then the real interest rate is 5%-3%= 2%

Interest Rates and Central Banks

The level of interest rates is determined by the demand and supply of money in an economy. However, the supply of money is affected by the country’s central bank.

Depending on economic activity, the central bank intervenes in the money market to raise / lower interest rates which in turns reduces / raises lending activity and boosts / weakens economic activity.

The central bank uses the following tools to lower short-term interest rates.

Open Market Operations

The central bank injects or withdraws liquidity in the banking system by purchasing or selling government securities like bonds in the open market.

When the central bank purchases financial securities it expands reserves and deposits in the banking system causing an increase in the money supply and a reduction of interest rates.

Discount Loans

Discount loans from the central bank to commercial banks lead to an injection of liquidity, an expansion of banking reserves which leads to an expansion of the money supply and lower interest rates.

Reserve Requirements

The central bank also uses reserve requirements to expand or contract money supply. The reserve requirement is a certain fraction of customer deposits all commercial banks must hold as reserves in the central bank. The rest of customer deposits can be used to make loans.

The central bank sets a reserve requirement which is a certain fraction commercial banks must hold. When the central bank raises reserve requirements it causes a reduction in money supply.

Expansionary monetary policy using the tools above involves the central bank buying short-term government bonds to lower short-term interest rates and encourage commercial banks to increase loans.

Central bank use other monetary policy tools to boost economic activity. Learn more about monetary policy.

Interest rates versus Currency

A country’s currency is affected by the central bank interest rate policy. Low interest rates make money cheaper and hence the currency weakens. On the other hand, high interest rates makes money more expensive and the currency strengthens.

Interest rates and the yield Curve

The yield curve is a line that plots interest rates of government bonds having equal credit quality but differing maturity dates. Bond maturities range from 3 months to 30 years.

The benchmark yield curve monitored closely for all economies is the spread between the 10-year bond and the 2-year bond. The 10-year to 2-year yield curve predicts economic conditions 4-5 years out.

The short-end (the 2-year bond) of the yield curve is driven by market expectations of central bank’s actions while the long-end (the 10-year bond) is driven by the market’s expectations of future economic conditions and the inflation outlook.