Carefully! Lots of text.

It makes no sense to lend money for free. Therefore, if Alice wants to borrow $10,000 from Boris, he will need a financial incentive to agree to borrow it. The incentive will be interest - a commission that is added to the amount of Alice's principal debt.

Interest rates have a significant impact on the economy as a whole, since raising or lowering them affects people's behavior:

  • High interest rates motivate people to keep money in the bank and receive rewards. At the same time, the number of borrowers decreases due to higher loan amounts.

  • And vice versa: low interest rates stimulate loans and purchases, as it becomes unprofitable to keep money. At the same time, borrowers do not have to pay huge amounts of interest.


Introduction

In the article How does the economy work? We have already written about the role of loans in the global economy. Essentially, it is a financial transaction facilitator, allowing people to use capital they don't have and pay it back later. Companies can take out a loan to buy resources, use them to make a profit, and then pay the lender. And the consumer can take out a loan to purchase goods and repay the debt in small installments.

Of course, getting a loan is impossible without a financial incentive to encourage lenders to lend money. That's why banks charge interest. In this article, we'll take a closer look at interest rates and how they work.


What is interest rate

The interest rate is the amount the borrower must pay the lender. If Alice borrows money from Boris, he might say he will lend $10,000, but only at an interest rate of 5%. This means that Alice will have to pay back the principal amount of $10,000 plus 5% by the end of the period. Thus, her debt to Boris will be $10,500.

So, the interest rate is a percentage of the principal amount borrowed for a specified period. If it is 5%, then Alice will have to pay $10,500 in the first year. There are two betting options:

  • simple interest rate: 5% of the principal amount will continue to accrue in subsequent years

or

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


Why Interest Rates Matter

As long as transactions are not made solely using cryptocurrency, interest rates affect them like most others. And even if payment for goods and services takes place in Dogecoin, the economy will still affect their value.

Take a commercial bank for example—its business model (fractional reserve banking) revolves around loans and refunds. If you invest money, you act as a lender and earn interest as the bank lends your funds to other people. Conversely, when you borrow money, you pay interest to the bank.

Commercial banks do not have enough flexibility to set interest rates. This is done by central banks such as the US Federal Reserve, the People's Bank of China or the Bank of England. Central banks support the economy through various mechanisms, including raising or lowering interest rates.

As already noted, high interest rates benefit lenders, while low interest rates benefit borrowers.

Ultimately, these measures control consumer behavior. Lower interest rates stimulate spending during sluggish periods, encouraging individuals and businesses to borrow and spend.

Lowering interest rates is an effective short-term step to stimulate the economy. However, low rates cause inflation as credit becomes more available while the supply of resources remains the same. In other words, the demand for goods increases, but the supply does not. Naturally, prices will rise until equilibrium is reached.

High interest rates can serve as countermeasures that reduce the amount of revolving credit through debt repayments. Since banks offer generous rates at this stage, people will be eager to invest money and earn interest. With less demand for goods, inflation falls, but economic growth slows.


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What is a negative interest rate

Economists and experts often talk about negative interest rates. As the name suggests, these are the sub-zero rates at which the lender pays the borrower for a loan or even for storing funds in a bank. In other words, it becomes unprofitable for banks to issue loans and store funds.

This may seem absurd, because the lender cannot be sure that the borrower will repay the debt. Why should he pay?

Negative interest rates are a last resort to solve economic problems. Banks are willing to pay to keep people investing rather than holding them during an economic downturn, preferring to wait until things recover.

Once negative rates are established, people begin to borrow and buy, creating a positive impact on the economy.


Summary

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

However, they are an integral part of the modern economy because changing them can fundamentally change the behavior of people and businesses. Therefore, central banks actively use them to support economic growth.

Do you still have questions about interest rates and the economy? Visit our Q&A Ask Academy platform where the Binance community will answer your questions.