The interest rate can just be defined as the cost of financing activity. When an organization or an individual borrows money, they must pay a rate to the lender to provide the lender with the compensation for the capital. Why would a lender lend money without any returns? The return is regarding annual payments based on a rate that is applied to the amount borrowed. The rate is mainly known as the interest rate. However, the rate is subject to changes on a continuous basis and many factors play a role in the ever-changing interest rates.
The market forces of demand and supply play a significant role in determining the rate of interest prevailing in the economy. The demand for credit and the supply of credit determine the rate of interest whereby an increase in demand for credit coupled with a decrease in the supply of credit will cause a rise in rates. Conversely, a decrease in demand for credit combined with an increase in the supply of credit would result in a decline in rates. The request for credit is essentially the demand for borrowing that comes about from individual borrowers and organizations. For example, if the economy is on a boom, it is likely that body would increase the level of investment whereas individuals would increase the standard of consumption. This would in effect increase the demand for credit and result in an increase in the rate of interest. Conversely, if the economic conditions depict a recession or a recovery, it is likely that organizations would be curtailing investments and individuals would be limiting their spending. This would decrease the demand for credit and ultimately result in a decline in interest rates. The ever-changing demand and supply conditions that are dependent on different factors are likely to cause changing rates.
The interest rates are not only dependent on demand for credit. The monetary policy of the government plays a significant role in the determining the rate of interest. The money supply within in economy determines the supply of credit and this, in turn, impacts the rate of these interest. The government uses open market operations and transactions for influencing the rate whereby if they buy securities; money is injected into the economy and the interest rate decreases whereas if they sell securities; money is withdrawn from the economy which results in a rise in the rates. Therefore the supply of credit is influenced by the monetary policy of the government.
The prevailing rate of inflation also has an impact on the rates. Rising inflation results in a higher nominal interest rate so that the real rate can remain active. Changing inflation rates indicate changing interest within an economy.
These factors determine the interbank rate which is then adjusted for default risk premium for individuals and organizations based on credit ratings. The forces of demand and supply change on a continuous basis depending on economic conditions and government’s monetary policy and therefore the rate of interest changes over a period.
Author of this article is Jason Leon, famous researcher of the machine learning to predict stock prices and active blockchain enthusiast. Jason lives in New York with his family. In his spare time, Jason likes to travel around the world, to visit different trading conferences and to meet new people.