Brief content

It makes no sense to borrow money for free. If Alice wants to borrow $10,000 from Bob, Bob needs a financial incentive to lend her the money. This incentive comes in the form of interest, a kind of fee, that is added to the amount that Alice borrows.

Interest rates have a strong impact on the economy as a whole because their rise or fall has a strong impact on people's behavior. Broadly speaking:

  • Higher interest rates make the economy attractive because banks pay you more to keep your money with them. Borrowing money is less attractive because you have to pay higher amounts on the loan you take out.

  • Lower interest rates make it attractive to borrow and spend money that doesn't generate much income when it's idle. What's more, you don't have to pay huge amounts beyond what you're doing.


Introduction

As we saw in How Does the Economy Work?, credit plays a vital role in the global economy. It's basically a lubricant for financial transactions, people can use capital they don't have and pay it back later. Businesses can use loans to buy resources, use those resources to make a profit, and then pay the lender. A consumer can take out a loan to buy goods, and then repay the loan in small installments over time.

Of course, first of all, lenders must have a financial incentive to offer a loan. They often charge interest. In this article, we'll take a closer look at interest rates and how they work.


What is an interest rate?

Interest is the payment the borrower owes the lender. If Alice borrows money from Bob, Bob can say that you can get this $10,000, but at 5% per annum. This means that Alice will need to pay back the original $10,000 (principal amount) plus 5% of that amount by the end of the period. Thus, the total payment to Bob is $10,500.

So, the interest rate is a percentage of the amount owed for the period. If it is 5% per year, then Alice will have to pay back $10,500 in the first year. It follows from this:

  • simple interest rate in subsequent years - 5% of the principal amount

or

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


Why are interest rates important?

Unless you're dealing exclusively in cryptocurrency, cash, and gold coins, interest rates affect you, too. Even if you somehow found a way to pay for everything in Dogecoin, you would still feel their impact because of their importance to the economy.

Take, for example, a commercial bank, its entire business model (partial reservation banking) revolves around borrowing and lending money. When you deposit money, you are acting as a lender. You earn interest from the bank because they lend your money to other people. In contrast, when you borrow money, you pay the bank interest.

Commercial banks do not have much flexibility when it comes to setting interest rates, which are set by organizations called central banks. For example - the US Federal Reserve System, the People's Bank of China or the Bank of England. Their job is to monitor the economy to keep it healthy. One of the functions they perform for these purposes is to raise or lower interest rates.

Think about it: if interest rates are high, you will receive more interest on the loan. On the other hand, it will cost you more to borrow because you will owe more. Conversely, giving loans at low interest rates is not very profitable, but borrowing is attractive.

Ultimately, these measures control consumer behavior. Lowering interest rates is usually done to stimulate spending during periods of slowdown, as it encourages individuals and legal entities to borrow. Then, when more credits are available, they will probably go and spend them.

Lowering interest rates may be a good short-term step to rejuvenate the economy, but it also causes inflation. More credits are available, but the number of resources remains the same. In other words, the demand for goods increases, but the supply does not. Naturally, prices begin to rise until equilibrium is reached.

In this case, high interest rates can serve as a countermeasure. Setting high rates reduces the volume of revolving credit, as everyone begins to pay off their debts. Since banks are offering generous rates at this stage, people will instead save their money to earn interest. With less demand for goods, inflation decreases, but economic growth slows down.


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What is a negative interest rate?

Economists and experts often talk about negative interest rates. As you understand, these are sub-zero rates that you have to pay to lend money or even keep it in the bank. More broadly, this makes lending to banks expensive. Moreover, because of this, it even becomes expensive to save.

This may seem like a crazy idea. After all, the lender is the one who assumes the risk that the borrower may default on the loan, why should he pay?

Maybe that's why negative interest rates are the last resort to fix the economy's problems. The idea stems from the fear that people may prefer to keep their money during an economic downturn, preferring to wait until it recovers to engage in any economic activity.

When interest rates are negative, this behavior doesn't make sense, and borrowing and spending seems like the smartest choice. This is why some see negative interest rates as an effective measure in extreme economic conditions.


Final thoughts

At first glance, interest rates seem like a relatively simple concept.

However, as we have seen, they are an integral part of the modern economy, and their adjustment can fundamentally change the behavior of people and enterprises. This is why central banks take such an active role, using them to keep countries' economies on track.