In brief

It makes no sense for people to lend money for free. If Alice wants to borrow $10,000 from Bob, Bob will need a financial incentive to lend it to her. That incentive comes in the form of interest – a fee added to the principal amount Alice borrows.

Interest rates have a profound impact on the broader economy because increasing or decreasing interest rates greatly impacts people's behavior. In short:

• Higher interest rates make saving money attractive because banks pay you more when you let them store your money. But borrowing money is less attractive because you need to pay a higher amount for the credit you borrow.

• Lower interest rates make borrowing and spending money attractive – your money doesn't earn much interest if it's idle. Furthermore, you do not need to pay a large amount compared to the loan amount.

Introduce

As we learned in the article How Does the Economy Work?, credit plays an important role in the global economy. In essence, it is a lubricant for financial transactions – individuals can take advantage of capital they do not have available and repay it later. Businesses can use credit to buy resources, use those resources to make a profit, and then pay the lender. Consumers can borrow to buy goods, then pay back the loan in installments over time.

Of course, there needs to be a financial incentive for the lender to provide credit in the first place. Usually, they will charge interest. In this article, we will go in-depth about interest rates and how this mechanism works.

What is interest rate?

Interest is the amount of money the borrower must pay to the lender. If Alice borrows money from Bob, Bob might say you can borrow this $10,000 but at 5% interest. That means Alice needs to pay back the original $10,000 (principal) plus 5% of that amount at the end of the period. Therefore, the total amount she must pay back to Bob is $10,500.

So, interest rate is the percentage of interest paid each period. If the interest rate is 5% per year, Alice will owe $10,500 in the first year. From there, you can calculate:

• Simple interest – subsequent years incur an interest rate of 5% of the principal amount

or

• compound interest – 5% of $10,500 in the first year, then 5% of $10,500 + $525 = $11,025 in the second year and so on.

Why is interest rate important?

If you don't make exclusive transactions with cryptocurrency, cash, and gold coins, the interest rate will affect you, just like it does for almost everyone else. Even if you somehow find a way to pay for things with Dogecoin, you will still feel the effects of interest rates because of the importance of this mechanism in the economy.

Take a commercial bank – their entire business model (fractional reserve banking) revolves around borrowing and lending money. When you save money, you are acting as a lender. You receive interest from the bank because they lend your money to others. Conversely, when you borrow money, you have to pay interest to the bank.

Commercial banks are not very flexible in setting interest rates – it is up to the so-called central banks. Examples include the US Federal Reserve, the People's Bank of China or the Bank of England. Their job is to regulate the economy to maintain growth. One function they perform to achieve these purposes is to increase or decrease interest rates.

For example, if interest rates are high, you will receive more interest when you lend money. If you are a borrower, you will owe more because you have to pay more interest on your loan. On the contrary, lending when interest rates are low will not bring much profit but becomes attractive as a borrower.

Ultimately, these measures control consumer behavior. Lowering interest rates is often done to stimulate spending during slow times because it encourages individuals and businesses to borrow. Then, when they have more credit, they are likely to borrow and spend.

Lowering interest rates may be a good short-term move to reinvigorate the economy, but causes inflation. There are more credits but the resources stay the same. In other words, demand for goods increases but supply does not change. Naturally, prices begin to increase until equilibrium is reached.

At that time, high interest rates can be used as a response measure. Setting interest rates high reduces the amount of credit circulating, as people start paying off their debt. Since banks offer very high interest rates at this stage, individuals will save money to earn interest instead of consuming. When there is less demand for goods, inflation falls – but economic growth slows.

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What are negative interest rates?

Experts and economists talk about the concept of negative interest rates. As you can imagine, this is a sub-zero interest rate that requires you to pay money to lend money – or even to keep it at the bank. If this situation continues for a long time, it will be costly for banks to lend money. Indeed, negative interest rates even make saving expensive.

This seems like a crazy concept. After all, the lender is assuming risk if the borrower might not be able to repay the loan, so why should they pay?

This is perhaps why negative interest rates are the last resort to fix struggling economies. This idea stems from the fear that individuals may prefer to hold onto money during economic downturns, wanting to wait until the economy recovers before engaging in economic activity.

When interest rates are negative, this behavior doesn't make sense – borrowing and spending seem like the most sensible options. That's why negative interest rates are seen by some as a reasonable measure in unusual economic conditions.

summary

On the surface, interest rates seem to be a relatively easy concept to understand.

However, this mechanism is an integral part of modern economies – as has been seen, adjusting interest rates can fundamentally change the behavior of individuals and businesses. This is why central banks take a proactive role in using interest rates to keep a country's economy on track.

Do you have any questions about interest rates and the economy? Follow our Q&A platform, Ask Academy, where the Binance Community will answer your questions.