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Why Do Interest Rates Matter?

Adam Lienhard
Why Do Interest Rates Matter?

The interest rate is the rate at which commercial banks are paid by the central bank for deposits made, whether it is an overnight investment or for a month or longer. This rate is an indicator of the interest rates of commercial banks, which should not be lower than the central bank’s rate. In this article, you will learn why interest rates are important and what influences them in the markets.

What is the interest rate?

The interest rate refers to the amount of money earned by the lender based on the amount borrowed and the duration of the loan. 

The interest rate is determined by the agreement between the lender and the borrower based on supply and demand. The higher the risk associated with the borrowing period, the higher the interest rate. 

Interest rates represent the return on investment for a specified period in exchange for the lender relinquishing control over their funds during the interest calculation period, which is typically annual.

Why do central banks need interest rates?

The interest rate helps the central bank control the amount of money in circulation. Central banks adjust this rate upward or downward in the medium term. If the interest rate is raised, borrowing activities decrease. It is leading to a decrease in liquidity and a subsequent decrease in the inflation rate.

What affects interest rates?

Understanding the factors that determine interest rates is crucial for anyone who wants to make informed trading decisions. Here are the six key factors that influence interest rates:

Monetary policy. Central banks are responsible for setting interest rates by adjusting the supply of money in the economy. Lowering interest rates can stimulate economic growth while raising them can curb inflation.

Inflation. When prices for goods and services rise, lenders may demand higher interest rates to compensate for the decrease in purchasing power over time. Central banks often raise interest rates to combat inflation and maintain price stability.

Economic conditions. GDP growth, employment levels, productivity, and consumer spending can impact interest rate decisions. Central banks may raise rates during economic expansion to prevent overheating or lower them during downturns to stimulate borrowing and investment.

Supply and demand for credit. The availability of credit and the demand for loans also affect interest rates. High demand for loans and limited credit supply can lead to higher interest rates, while a surplus of credit and low demand can cause rates to decline.

Government debt and fiscal policy. Higher government borrowing can increase the demand for credit, leading to higher interest rates. Additionally, government policies that affect spending, taxation, and budget deficits can influence interest rate decisions.

Global factors. International economic factors, such as exchange rates, global financial stability, and geopolitical events, can influence interest rates. Changes in global interest rates or shifts in investor sentiment can affect the borrowing costs for a particular country, impacting its domestic interest rates.

The specific weight and interplay of these factors can vary across countries and regions. Central banks have the primary responsibility for setting and adjusting interest rates in their respective jurisdictions.

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