Résumé
It doesn't make sense to lend money for free. If Alice wants to borrow $10,000 from Bob, Bob will need a financial incentive to lend her the money. This incentive is in the form of interest, a type of fee that is added to the amount Alice borrows.
Interest rates have a profound impact on the broader economy, as whether they rise or fall greatly affects people's behavior. In general :
Higher interest rates make saving more attractive because banks pay you more to deposit your money with them. It is less attractive to borrow money because you have to pay higher amounts on the credit you take out.
Lower interest rates make borrowing and spending attractive. Your money earns you very little by remaining idle. Plus, you don't need to pay huge amounts on top of what you borrow.
Introduction
As we saw in the article How the Economy Works?, credit plays an essential role in the global economy. Simply put, it is a lubricant for financial transactions. Individuals can take advantage of the capital they do not have available and repay it later. Businesses can use credit to purchase resources, use those resources to make a profit, and then repay the lender. A consumer may take out a loan to purchase goods and then repay the loan in small installments over time.
Of course, there must be a financial incentive for a lender to offer credit in the first place. Often they charge interest. In this article, we will discuss interest rates and how they work.
What is an interest rate?
Interest is a payment owed to a lender by a borrower. If Alice borrows money from Bob, Bob could tell her that he can lend her the $10,000, but with an interest rate of 5%. This means that Alice will have to repay the original amount of $10,000 (the principal) plus 5% of that amount before the end of the period. His total reimbursement to Bob is therefore $10,500.
So, an interest rate is a percentage of interest owed per period. If it's 5% per year, then Alice will owe $10,500 in the first year. From there you could have:
a simple interest rate: in subsequent years the interest rate is 5% of the principal
or
a compound interest rate: 5% of $10,500 in the first year, then 5% of $10,500 + $525 = $11,025 in the second year, etc.
Why are interest rates important?
Unless you trade exclusively in cryptocurrencies, cash and gold coins, interest rates affect you, like everyone else. Even if you found a way to pay for everything in Dogecoin, you would feel the effects due to their importance in the economy.
Take a retail bank: their entire business model (fractional reserve) is based on borrowing and lending money. When you deposit money, you act as a lender. You receive interest from the bank because it grants your funds to other people. On the other hand, when you borrow money, you pay interest to the bank.
Retail banks do not have much flexibility in setting interest rates. This task falls to entities called central banks. For example, we have the American Federal Reserve, the People's Bank of China or the Bank of England. The job of these banks is to appeal to the economy to keep it healthy. One of the functions they perform for these purposes is to raise or lower interest rates.
Think about it: if interest rates are high, you will receive more interest for lending your money. On the other hand, it will cost you more to borrow, since you will have a larger debt. Conversely, it is not very profitable to lend when interest rates are low, but it becomes attractive to borrow.
Ultimately, these measures control consumer behavior. Lowering interest rates is usually done to stimulate spending when spending is slowing, because it encourages people and businesses to borrow. Then, with more credits available, they will be happy to spend them.
Lowering interest rates may be a good short-term measure to revive the economy, but it also causes inflation. There are more credits available, but the number of resources remains the same. In other words, the demand for goods increases, but the supply does not. Naturally, prices begin to increase until an equilibrium is reached.
At this point, high interest rates can serve as a countermeasure. Raising them reduces the amount of credit outstanding as everyone starts paying off their debts. As banks offer generous rates at this stage, individuals will instead save their money to earn interest. With less demand for goods, inflation falls, but economic growth slows.
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What is a negative interest rate?
Economists often talk about negative interest rates. As you can imagine, these are sub-zero rates, so you have to pay to lend money, or even store it in a bank. By extension, it is expensive for banks to lend. Indeed, it makes even saving expensive.
This may seem crazy. After all, it is the lender who bears the risk that the borrower will not repay the loan, why should they pay?
Perhaps this is why negative interest rates are part of a last resort to remedy economic difficulties. The idea comes from the fear that individuals prefer to hold on to their money during declines in economic activity, in order to wait for activity to resume before spending.
When rates are negative, this behavior makes no sense. Borrowing and spending seem to be the wisest choices. This is why negative interest rates are considered a relevant measure by some in exceptional economic conditions.
To conclude
On the surface, interest rates seem like a relatively simple concept to understand.
Nevertheless, they are an integral part of the modern economy. As we have seen, adapting them can fundamentally change the behavior of individuals and businesses. This is why central banks play such a proactive role in using them to keep countries' economies on track.
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