Forces That Impact Interest Rates

Wednesday May 29th, 2019


Interest rates change primarily by the forces of Supply and Demand, which are also affected by Inflation and Monetary Policy. 


Lenders and Borrowers

An Interest rate is the cost of borrowing money. ...  it is the compensation for the service and risk of lending money. It keeps the economy moving by encouraging people to borrow, to lend, and to spend.

The money lender takes a risk that the borrower may not pay back the loan. Coupled with the risk of default is the risk of inflation. When you lend money now, the prices of goods and services may go up by the time you are paid back, so your money's original purchasing power would decrease. Thus, interest protects against future rises in inflation.

Borrowers pay interest because they must pay a price for gaining the ability to spend now, instead of having to wait years to save up enough money.

Businesses... also borrow now to buy equipment so they can begin earning those revenues today. Banks borrow to increase their activities, whether lending or investing and pay interest to clients... 

Interest can thus be considered a cost for one entity and income for another.


How Interest Rates Are Determined


1. Supply and Demand

... an increase in the demand for money or credit will raise interest rates...  a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.

For example, when you open a bank account, you are lending money to the bank thus increasing the money supply available to borrowers.

...when you choose to postpone paying this month's credit card bill until next month ..., you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market.


2. Inflation

... the higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they are paid in the future.


3. Government

The Bank of Canada raises and lowers the Target for the overnight rate. The "overnight rate" is the interest rate at which major financial institutions borrow and lend one-day funds among themselves).

Changes in the target for the overnight rate usually lead to changes in other interest rates, and so affect people's spending decisions. This, in turn, influences the level of demand for goods and services. When demand exceeds supply, prices will rise.



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