To any economist, the most important terms are demand and supply-both individual and market. In fact, we can say that the two terms sums everything and affects every economic concept. Another term or concept that I tend to rank slightly below the demand and supply is the concept of interest rates, though it is dependent on supply and demand. Interest rates will play a major role in the economy and can also be used as an indicator of the performance of an economy. Any government, investor, trader or financial institution that does not have a proper policy to deal with the prevailing and the future interest rates is bound to fail. When dealing with a country’s economy, Interest rates target is a vital concept in formulating the monetary policies. We have to consider it when dealing with major aggregate variables like inflation, investments, unemployment and output.
For example consider this, a government will reduce the rate of interest when it wants to spur investments, output, and consumption and therefore reduce the rate of unemployment. However, the low interest rates must be monitored as it might lead to inflation and creation of economic bubbles that is characterized by huge investments in the stock and the real estate sectors. When this happens the government has to push up the rate of interest rates to control the bank’s lending and encourage investments in other sectors. The government will also want to control the interest rate to keep inflation within at certain range for the health performance of an economy.
To understand this concept, we shall first define what interest rate is? Interest rate is simply the rate at which borrowers are willing to pay to lenders as a percentage of the principal amount for using the money borrowed from the lenders. The interest rate can be simple or compounded. Under simple interest the borrower is charged a fixed amount of interest that does not accrue over the lending term. The compound interest will accrue over each period be it instantaneously or what we call force of interest or annually. The interest rate reported mostly in the media houses is the overnight lending rates to banks by the central bank of a country. This type of interest rate will mostly affect small investors but not the overall economy. To get the interest rate in an economy, we consider a composite index that takes into account all interest payments and capital from investments.
The prevailing interest rate in the economy will be determined by severally factors but the main one is the future expected risks and the risk market free rate. The lenders funds must be protected against future unforeseeable risks. Therefore a risk premium should be added to the risk free rate to give us the interest rate. We usually consider the treasury bills yield rates as the market free rate because the treasury bills have a zero credit risk as it is issued by the government. Other factors that will affect the interest rates are the expected inflation rate, liquidity preference, taxes and alternative investments.