“Interest rate dropped by 0.25%”, we often hear such headlines making the news now and then, but only a few rack their brains to interpret the logic behind these changes.
Why do interest rate changes over time?
The very basic reason being, the economic situation of a country doesn’t remain the same over a period. Sometimes there is a boost in economic activities and other times there is a slowdown, so to keep it balanced, the interest rate is changed accordingly. Changes in interest rate reflect the demand from borrowers and the supply of funds available to be loaned.
The interest rate is a significant economic variable that plays a crucial role in the economy. Just like the stock exchange acts as an economic barometer of an economy, any change in interest rate indicates the economic situation of operations of an economy. Every economy faces ups and downs and the Central bank closely monitors these economic changes. When it seems there is an economic slowdown then it reduces the interest rate causing a fall in the cost of borrowing which will prompt businesses to take more loans to make new investments and vice versa.
Determinants of the interest rate
Inflation: It is the key determinant of interest rate, the Central bank uses this tool to keep a check on inflation. If the inflation rate is rising then the Central bank will increase the rate as a result, less investment will take place leading to less income and less purchasing power in the hands of consumers ultimately leading to deflation.
Monetary policy: As a part of monetary policy Central banks try to control the money supply in an economy. If there is a greater money supply in the market than this will lead to higher purchasing power in the hands of consumers which will trigger inflation, unexpectedly causing other economic problems. So to lower the money supply it is required to increase the interest rates.
Advantages of a higher rate of interest
•It helps to control demand for credit, lowering the growth of money supply, and helps to control demand-pull inflation.
•Increase in mortgage rate will cause a slowdown in house price inflation, making the property more affordable over time.
•Higher interest rates will induce savings, raising more disposable income for the future.
•It reduces the risk of mal-investments (e.g. bitcoin) as it goes up because of the cheap cost of borrowing.
Disadvantages of a higher rate of interest
• There is a risk of a slowdown in consumption if retail credit becomes more expensive.
• It might block the much-needed business investments.
• Rising rate can cause the exchange rate to appreciate making export less competitive, leading to export slowdown.
• It also makes government debt more expensive which further can slow down a country’s development.
Interest rate is of two types: Nominal and Real interest rate
Nominal interest rate- in this type no consideration is given to inflation it means that it is not adjusted with inflation e.g. A deposited 1000$ in a bank, after one year he receives 1100$ which means that the rate of interest is 10%p.a. regardless of the inflation rate.
Real interest rate- Here due consideration is given to inflation and the interest rate is adjusted about the inflation rate. Taking the same example if the inflation rate is 10% then after adjusting, the real interest rate would be zero. It looks like A is having 1100$ with him but due to inflation the prices of various goods will also rise causing no change in his purchasing power.
Other than these there is one called Negative interest rate, in which the lender rather than collecting interest, has to pay it to the borrower. Such a scenario occurs during a recession when the demand is deficient but not necessarily. Many instances can be seen when the negative rate of interest has been applied during the normal course of time, For Example, In mid-2019 in Japan, when the rate was -0.1%.
Interest rate and investment
Interest rate and investment are closely linked to each other. Any change in interest rate will have a direct impact on investment, In Fact, they have an inverse relation, i.e. any rise in interest rate will lead to a fall in investment level and vice versa. The relation of interest rate and investment is shown by a downward sloping graph.
Interest rates highly influence investments. It is because of the cost of borrowing that links them together.
To understand it more let’s take an example, An inter-departmental study was done by RBI in 2011, it was noted that for more than eighteen successive months since July 26, 2011, the RBI’s repo rate was maintained at or above 8 per cent. Consultations with representatives of industry and commercial banks revealed that the real interest rate has an implicit role in influencing the investment. Estimates suggest that at macroeconomic level a 100 bps increase in real interest rate lowers the investment to GDP ratio by about 50 bps in the long run. Overall, the study finds evidence that lower interest rates can stimulate growth and investment.
No doubt the Interest rate has great influence but it is not solemnly responsible to cause any change in investment level. It is affected by many other factors like market size, economic development, investment environment, preferential policies, etc. Also, the interest rate neither keeps on rising or falling, there is a very slight fluctuation in the interest rate that occurs. Change in interest rate is a part of the vicious circle of the economy connecting various other economic variables to maintain an ideal situation in the economy.
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