Interest rate is a mechanism that affects everyone’s lives- even if they’re aware or not, as the price of money is known as the interest rate. Interest rate is the percentage of principal amount charged by a lender to the borrower for using their resources whereas, Interest is the amount paid per period for the principal lent or borrowed. A country’s interest rate is set by its central bank in order to make changes in the monetary policies of a country. This rate acts as a benchmark for interest rates on credit cards, mortgages, and bank loans, and is an important tool to maintain the economy. An interest rate can be zero and as well as negative, for instance in an economy like Japan.
The rates are changed to control inflation, liquidity and to stimulate growth for any economy. Inflation is a general increase in prices and fall in the purchasing value of money. A second class stamp paper cost 19 paise in 2002, so a customer could buy 5 stamps per rupee. In 2012 the same stamp cost around 50 paise per stamp, i.e., 2 stamps can be bought in 1 rupee.
The hike in this price over the 10 years is a result of inflation. The increase in the cost is directly associated with the loss of value of money, as borrowing from banks becomes easier with reducing interest rates over time. Low-interest rates encourage consumption which makes the situation favorable to the overly optimistic investors and businesses. But the economies don’t grow exponentially and as a matter of fact, it grows cyclically and so a period of remarkable growth is usually followed by a downfall. When central banks raise the interest rates it means higher cost of borrowing money and this is done to cool down an overheated economy and control inflation.
For businesses and entrepreneurs, the changing interest rate means much more than simple borrowings and lending concepts as their future forecast and planning is done accordingly. For instance, it’s easier to do capital investment and start new projects when interest rates are lower, but the same project loses its profitability in the long run if the expected interest payment increases drastically. A higher interest rate decelerates the growth and expansion of business and slows down the economy whilst lower interest rates act as a fuel for the growth.
Changing interest rates directly affects the decision people, as individuals make with their money that is; whether to save, spend or invest it. A saver is paid interest for postponing his current spending whereas a borrower pays interest for using other’s funds. So a higher rate on deposits attracts people to save and when the interest rates are lowered a shift to investment can be seen as a more viable option which gives expectations of better return.
For the investors, there’s a saying- higher the risk, higher the returns. Changing interest rates directly affects the investors as, when the cost of borrowing increases, banks seem to be a more secure option with good returns and less risk, thus attracting the investors. Decrease in bank’s interest rates discourages the savers and a shift is seen from banks to the stock market. Bond market becomes an attractive investment option when the interest rates increases as the risk factor with the bonds are also less.
Interest rates are also one of the measures used to attract foreign investors. Higher interest rates result in soaring demand for a currency, as foreign investors try to enter the markets fascinated by better returns on investments. This affects the FOREX market directly and usually the impact of these changes in monetary policies is reflected on the FOREX market sooner than its implementation in the economy. Similarly, when interest rates are lowered by the central bank, price of that particular currency shows a downward trend on the FOREX market.
Reduction in interest rates is also seen during a financial crisis as the one seen in 2008 or due to an emergency response to an outburst like the COVID-19. A lot of countries are reducing their interest rates to push their economy. The United States of America has also lowered their rates to almost 0% which further suggests the economic collapse worldwide. Interest rates are reduced to negative in order to build back a collapsing economy, in such cases banks make low profits but this helps the investors and borrowers to make profit as the value of local currency goes down making the imports expensive and stimulating exports, uplifting the economy.
This article is co-authored with Prof Syed hasan Jafar, Aayushi and Arvind Reddy M, Woxsen University.