Why do interest rates rise and fall?

In the world of finance, interest is the cost associated with borrowing money. If you borrow $ 1000 at an interest rate of 10 percent, you have to pay back $ 1100. The extra 10% represents the interest charged by the lender, and $ 100 is the price you pay to borrow money. The cost of borrowing, or the interest rate can increase or decrease, depending on how much money is available in the system. Governments often rise or lower interest rates to control adverse economic conditions or as a proactive way of trying to direct the national and international economic performance in a specific direction.

Money Supply – a reason for fall and rise in interest rate:

The level of supply of any goods is usually the main cause of fluctuations in its price. The institutions such as banks that lend money, use the funds they receive through savings by customers, lend it to borrowers. The interest paid against a savings accounts are typically lower than the interest that banks charge the borrowers. When the money supply is low, like when other investments such as stocks and shares provide a higher return, banks increase interest rates paid to depositors to encourage deposits. As banks indeed are paying more for the money they lend to borrowers, they have to charge them more, causing interest rates to rise. When lending institutions have more money than what the borrowers want to, they have to compete with others, by lowering interest rates to attract new borrowers.

Inflation influence interest rates:

Inflation occurs when prices of goods and service rise in the economy. This can happen when there is greater demand for goods and services that the economy can offer. Bidders are then able to charge higher prices. When this happens, people find that they can no longer afford to buy the goods that they were previously able to. This is known as cost-push inflation. Typically people react to cost-push inflation demanding higher wages. Manufactures then increase the prices of goods further to pass the cost of increase in wages to consumers. This combination of cost-push inflation and wage inflation affects the economy adversely. Central banks typically use interest rates to try to control inflation. Rise in interest rates, decreases the demand for loan and so does spending of households with mortgages. Normally mortgages cost more when the central bank raises the interest rates. This reduces the spending power in the economy. Reduction in demand keeps the rising prices in tact. The need to control inflation is one of the major reasons why governments increase interest rates.

Economic slowdown

When there is a slowdown in economy, or when the production capacity in industrial or commercial sectors falls, or when the growth output begins to slow, interest rates tend to fall. During the times when the economy slows, companies tend to postpone projects that involves expansions because there is uncertainty to achieve the necessary sales to justify these projects. When companies reduce spending in this way, and reduce the need for loans, lenders have to reduce their interest rates to compete in business to get more potential borrowers. In a pure market sense, interest rates should fall to the rate at which borrowers find it cost-effective to borrow again.

Value of currency influence interest rates:

The currencies of countries with successful economies based on international trade tend to grow in value relative to other currencies. This occurs because other countries use their own currency, or foreign currencies to buy the successful currency. Many goods such as oil are traded in dollars. When the currency of a country has a greater value in a particular country, importers need to spend less of their currency to buy goods from abroad, but exporters will find it hard to sell to foreign consumers because they have to spend more of their own currency to buy goods. One way for governments to control the value of their currencies is increasing or lowering interest rates. When a country lowers its interest rates, the value of its currency usually falls compared to the value of other currencies. This makes exports more attractive, while making imports less attractive. The drop in the interest rate in one of the measure adopted by governments to improve the balance in trade in relationship with other countries around the globe.

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