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Interest Rate – A major economic force affecting financial plans

Updated on July 1, 2017

Rate of interest is the price of money which is lent or borrowed. It is always expressed as a percentage of the sum lent or borrowed. It is generally calculated on an annual basis.

Generally, the longer the time period of a loan, the higher the rate of interest because of the greater risk and uncertainty involved. However, two loans for the same time period might carry different rates because some borrowers are safer than others.

Term Structure of interest rates

Long term rates are normally higher than short term rates due to the additional risks borne by the lender. An interest premium is therefore required to attract investors to longer-term securities. However, this effect may be magnified or reversed by investors expectations of future rates.

The difference between long and short term rates is called as Term Structure. It is shown graphically by the Yield Curve. Graph below shows an upward sloping yield curve which is the normal situation. This shows that the long term rates are to be higher than the rates available in the short term.  Upward sloping yield curve compensates investors for tying up their money for longer periods.

Yield Curve - Term Structure of interest rates
Yield Curve - Term Structure of interest rates

Short term interest rates are sometimes used as a tool by the central bank of a country to combat inflation. Their influence is primarily directed towards short term interest rates as a means of managing inflation in the country’s economy. As a result, at that time the long term interest rates may be lower than the short term rates. Art that moment, the yield curve will be downward sloping or inverse.

Inverse Yield Curve
Inverse Yield Curve

How changes in interest rates affect the economy

The main effect of an increase in interest rates are given below:

  • Expenditure falls

Spending of individuals and businesses will be reduced when interest rates go up. Consumers are left with a lesser income for spending on goods and services due to higher interest payments. Fall in spending leads to less aggregate demand in the economy and this results in unemployment in the country.

  • Asset value falls

The market value of financial assets will fall and that reduces the wealth of many people. In order to maintain the value of their total wealth, people will reduce spending and save money. This reduces the total expenditure in the economy further.

  • Foreign funds are attracted to the country

Overseas investors are encouraged to deposit money in the country’s banks because their return is greater than in other countries. Banks could make these funds available to the firms in the country.

  • The exchange rate rises

The inward remittances of foreign funds increase the demand for the domestic currency. This appreciates the local currency and pushes up the exchange rate of the domestic currency. This will make exports more expensive to other countries. However, the appreciation in the domestic currency will lower the import prices and it will favorably affect the domestic inflation rate.

  • Inflation falls

People will defer new borrowing and therefore demand will fall. Less demand in the economy may encourage producers to reduce prices by squeezing their profit margins. Producers are pressurized to cut costs in order to reduce export prices. Workers are laid off and total demand is reduced and inflation will fall.

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