Interest Rates - Factors Influence It
Interest rate is the rate of interest charged for the amount of money borrowed. Banks or lending institutions usually have general guidelines for the rate they intend to charge. Money borrowed by the bank on short term basis (such as overdraft facility) or long term basis (debentures, mortgages or bank loans) has different interest rate.
There are factors that influence the level of market interest rates:
• Expected levels of inflation
Over time, as the cost of products and services increase, the value of money decreases. Consumer will therefore have to spend more money for the same products or services which had cost less in the previous year. As for finance lending sector, borrowers may find it is attractive to borrow now but less attractive for lender. The value of money now has fallen as compared to the time when they lent their money. In order to compensate this loss, lenders have to increase the interest rate.
Demand and supply of money
Supply and demand is a fundamental concept in market economy. In general, supply refers to the level of quantity of services or products can be offered, while demand refers to the quantity required for the services and products. Demand and supply of money can affect interest rates. In United States, The Federal Reserve Bank has taken a step to manipulate money supply through an open market operation, by purchasing large volumes of government security to increase money supply, thus reduce the interest rates, or sell large volumes of government security to reduce money supply which will subsequently increase interest rates.
On the other hand, liquidity preference theory is linked to demand of money. Developed by John Keynes, this theory explains how demand and supply for money influence interest rates. It states that demand for liquidity is determined by transaction, precaution and speculation motives.
Therefore the supply of money interacts with liquidity-preference curve to determine the level of interest rate at which the quantity of money demanded equals supply.
Monetary policy and intervention by the government
One of the government’s strategies to control the flow of money within its consumers is by monetary policy. People will avoid borrowing money when the interest rates are high. This in turn will reduce the money outflow and affect the country’s revenue as consumers will not be spending unless it is necessary. In order to stimulate growth, government may offer lower interest rates on borrowing which subsequently attracts consumer to spend more borrowing. As a result, when the growth rate increases rapidly to the extent that economy may face overheat problem, the government then have to curb this by imposing higher interest rates.
General economic conditions
Economic condition may face series its booms and slumps. The world economy has been on the slump side since the past five years with many business closures. Banks are unable to provide loan at lower rate as they have to cover their cost.
Apart from the above, other factors such as political and financial stability and investors’ demand for debt securities also affect interest rates. While increase in interest rates helps consumer to save more, it is not a good news for lenders and business as they lose their revenue. Globally, this also adversely affects the world economy.