What affects interest rates?

What is the interest rate?

The interest rate is the cost of borrowing money, expressed as a percentage of the principal over a specific period, typically one year.

For example, a company (the borrower) may obtain capital from a bank (the lender) to invest in new assets. In return, the lender charges interest at a predetermined rate. In simple terms, the interest rate represents the price paid for the temporary use of money.

Interest rates are a key tool used by central banks in monetary policy and play a crucial role in influencing economic variables such as investment, inflation, and unemployment.

History

The concept of charging interest dates back to ancient times, with early references found in texts from the Abrahamic religions.

During the Middle Ages, the influence of the Catholic Church led to the widespread rejection of interest, often equating it with usury. Charging for the use of money was considered morally unacceptable, as time and goods were believed to belong to God.

During the Renaissance, money began to be viewed as a commodity. As a result, it could be bought, sold, or leased, and interest came to be understood as the “rental price” of money.

With the development of classical economic theory, the study of interest rates became more formalized. Economists such as Mirabeau, Jeremy Bentham, and Adam Smith analyzed interest as a function of supply and demand. In this framework, the interest rate can be seen as the “price of money,” leading to the development of the concept of financial capital.

In the early twentieth century, Irving Fisher introduced a mathematical approach to interest rates, distinguishing between nominal and real interest rates. By incorporating inflation, Fisher showed that the real interest rate reflects the difference between the present value of money and its future value.

Later, economists such as John Maynard Keynes and Milton Friedman further developed modern theories of interest rates and monetary policy.

Nominal vs Real Interest Rate

The nominal interest rate is the rate expressed in monetary terms, without adjusting for inflation.

For example, if you deposit $100 in a bank for one year and earn $10 in interest, your final balance will be $110. In this case, the nominal interest rate is 10% per year.

However, the real interest rate adjusts for inflation and reflects the actual purchasing power of the returns. If inflation is also 10% during that year, the $110 will have the same purchasing power as $100 had at the beginning of the period. Therefore, the real interest rate would be zero.

This relationship is described by the Fisher equation:

• in = Nominal interest rate
• ir = Real interest rate
• pe = Expected inflation rate for the year

Interest rates in macroeconomics

Interest rates are a major determinant of investment at the macroeconomic level. In general, higher interest rates increase the cost of borrowing, which tends to reduce investment and slow economic activity.

However, there are differing perspectives. For example, the Austrian School of Economics argues that higher interest rates may encourage savings and more efficient capital allocation, potentially supporting long-term investment and growth.

Central banks influence commercial interest rates by setting benchmark rates at which financial institutions can borrow. Changes in these rates affect borrowing costs across the economy, influencing business investment and overall economic activity.

Interest rates of Central Bank

The most obvious, visible and powerful tool of central banks in monetary policy is the influence on commercial interest rates, as mentioned above. The mechanism through which the central banks carry out this action may differ from one country to another but all rely on the central bank’s ability to increase or decrease the monetary resources available as needed.

The mechanism for moving the market toward a “target rate” (if this goal is pursued, as is the case for most of Central Banks) is usually lend or buy money in amounts theoretically unlimited until the rate of target market is sufficiently close to the target.. Central banks can do so by borrowing money or taking deposits from a limited number of qualified banks or by buying and selling bonds. For example, the Bank of Canada sets a target interest rate of ± 0.25% in the overnight market. Qualified banks can borrow from each other at an interest rate within this band but never above or below as the central bank always pay them on top of the band and takes deposits at the bottom of the band; in principle, the ability to borrow or lend at the ends of the band are limitless. Other central banks use similar mechanisms.

Also keep in mind that interest rate objectives are usually short term. The actual rate that borrowers and lenders receive in the market depends maninly on the perceived credit risk and other factors. For example, a central bank can set a target rate for overnight loans of 4.5%, but at the same time set a five-year bonds rate (similar risk) to a different rate, for example 5%, 4.75 %, or, in cases of inverted yield curves, even below the short-term rate. Many central banks have a key interest rate that is referred to as the “central bank rate”. In practice, central banks have other tools and can use other interest rates although only one, called “central bank rate” is tightly controlled by its objectives.

A typical central bank has several interest rates or monetary policy instruments that can be used to influence markets.

• Marginal lending rate – a fixed interes rate for institutions that borrow from the central bank. (in some countries known as discount rate).
• Main financing rate – the interest rate visible to the public and announced by the central bank. It is also known as minimum bid rate and serves as the minimum bid for refinancing loans. (In the United States known as Federal Funds Rates).
• Passive interest rate – interest received on deposits at the central bank.

Negative Interest Rates

Interest rates are typically positive, as lenders expect compensation for lending money. However, in certain economic conditions, negative interest rates have been implemented.

Historically, economists such as Silvio Gesell proposed negative rates to stimulate spending.

In modern times, central banks such as Sweden’s central bank (Sveriges Riksbank) have implemented negative interest rates (e.g., -0.25% in 2009) to combat deflation and stimulate economic activity.

In such cases, lenders effectively pay to hold safe assets, reflecting extreme market conditions and high demand for security.