Interest Rates
Interest rates, or the rate of return on a financial asset, can be expressed as a percentage reflecting the cost of borrowing money; they are determined by the current amount of available investments and demand in relation to the cost of funds. While loans and similar debt instruments often come with a specified loan rate charged by the lender, investments such as stocks and bonds also have their own rate to account for risk and volatility.
In market economies, interest rates serve as a signaling mechanism for the allocation of resources and capital. Depending on the current market conditions, a greater rate of return for an investment can mean a smaller pool of interested investors, meaning more expensive money and low liquidity, the opposite of what is happening when rates are low. Investors are more likely to invest when the rate is high, meaning financial markets are more liquid, steep competition amongst lenders keeps prices low and disruptive events such as economic crises are more likely to be avoided.
In this context, central banks act as economic policymakers, utilizing interest rate changes as part of their overall strategy. Central banks employ a variety of monetary policies to affect the amount of money circulating in the economy, either reducing or increasing the money supply depending on the prevailing economic state. By setting interest rates, the central bank increases or decreases banks costs of obtaining money, thus influencing the amount of money that the banks choose to lend to borrowers.
Ideally, a central bank will employ monetary policy to create stability in the economy by keeping inflation at a certain level and preventing any dramatic changes with regards to employment, prices and other related conditions. As a result, any changes to the interest rates are usually in response to a dynamic external environment, intended to keep the economy in a state of equilibrium.
In addition to changes to the interest rates, a central bank can also employ certain policies that have implications for market interest rates. These include open market operations and bond buying and selling, which affects the investors perception of risk and thus alters the market interest rate. One example of such a policy is Quantitative Easing (QE), which is an instrument of monetary policy in which a central bank purchases large quantities of assets in order to inject large amounts of cash into the economy.
Interest rates are some of the most important instruments of monetary policy, as they directly and indirectly affect a variety of economic factors such as investment, spending and consumer confidence. Higher interest rates also act as an incentive to save as people are more likely to think twice before borrowing money, thus affecting overall consumer spending. Finally, interest rates can affect a country’s credit score, with lower rates indicating a higher creditworthiness.
