Interest rates profoundly impact the broader economy, as raising or lowering them greatly affects people’s behavior. Broadly speaking:
- Higher interest rates make it attractive to save money because banks pay you more for storing your money with them. It’s less attractive to borrow money because you need to pay higher amounts on the credit you take out.
- Lower interest rates make it attractive to borrow and spend money – your money doesn’t make much by sitting idle. What’s more, you don’t need to pay huge amounts on top of what you borrow.
Of course, there needs to be a financial incentive for a lender to offer credit in the first place. Often, they’ll charge interest. In this article, we’ll take a dive into interest rates and how they work.
What is an interest rate?
So, an interest rate is a percentage of interest owed per period. If it’s 5% per year, then Alice would owe $10,500 in the first year. From there, you might have:
- a simple interest rate – subsequent years incur 5% of the principal
- a compounded interest rate – 5% of the $10,500 in the first year, then 5% of $10,500 + $525 = $11,025 in the second year, and so on.
Why are interest rates important?
Think about it: if interest rates are high, then you’ll receive more interest for loaning your money. On the flip side, it’ll be more expensive for you to borrow, since you’ll owe more. Conversely, it isn’t very profitable to lend when interest rates are low, but it becomes attractive to borrow.
Ultimately, these measures control the behavior of consumers. Lowering interest rates is generally done to stimulate spending in times when it has slowed, as it encourages individuals and businesses to borrow. Then, with more credit available, they’ll hopefully go and spend it.
At that point, high interest rates can serve as a countermeasure. Setting them high cuts the amount of circulating credit, since everyone begins to repay their debts. Because banks offer generous rates at this stage, individuals will instead save their money to earn interest. With less demand for goods, inflation decreases – but economic growth slows.
What is a negative interest rate?
This is perhaps why negative interest rates are something of a last resort to fix struggling economies. The idea comes from a fear that individuals may prefer to hold onto their money during an economic downturn, preferring to wait until it recovers to engage in any economic activity.
When rates are negative, this behavior doesn’t make sense – borrowing and spending appear to be the most sensible choices. This is why negative interest rates are considered to be a valid measure by some, under extraordinary economic conditions.
On the surface, interest rates appear to be a relatively straightforward concept to grasp.
Nevertheless, they’re an integral part of modern economies – as we’ve seen, adjusting them can fundamentally alter the behavior of individuals and businesses. This is why central banks take such a proactive role in using them to keep nations’ economies on track.