The interest rate can simply be defined as the cost of financing an activity. When an organization or an individual borrows money they must pay a rate to the lender in order to provide the lender with the compensation for the capital. Why would a lender lend money without any returns? The return is in terms of annual payments based on a rate that is applied at the amount borrowed. The rate is essentially known as the interest rate. However, the rate is subject to changes on a continuous basis and many factors play a role in the ever changing interest rates.
The market forces of demand and supply play a major role in determining the rate of interest prevailing within the economy. The demand for credit and the supply of credit determine the rate of interest whereby an increase in demand for credit coupled with a decrease in supply of credit will cause a rise in rates. Conversely, a decrease in demand for credit coupled with an increase in supply of credit would result in a decline in rates. The demand for credit is essentially the demand for borrowing that comes about from individual borrowers and organizations. For example, if the economy is on a boom, it is likely that organization would increase the level of investment whereas individuals would increase the level of consumption. This would in effect increase the demand for credit and result in an increase in the rate of interest. Conversely, if the economic conditions depict a recession or a recovery it is likely that organizations would be curtailing investments and individuals would be limiting their spending. This would decrease the demand for credit and ultimately result in a decrease in interest rates. The ever changing demand and supply conditions that are dependent on different factors are likely to result in changing rates.
However, the interest rates are not only dependent on demand of credit. The monetary policy of the government plays an important role in the determining the rate of interest. The money supply within in economy determines the supply of credit and this in turn impacts the rate of interest. The government uses open market transactions for influencing the rate whereby if they buy securities, money is injected into the economy and the interest rate decreases whereas if they sell securities, money is withdrawn from the economy which results in a rise in the rates. Therefore the supply of credit is influenced by the monetary policy of the government.
The prevailing rate of inflation also has an impact on the rates. Rising inflation results in a higher nominal interest rate so that the real rate can remain positive. Changing inflation rates indicate changing interest within an economy.
These factors determine the interbank rate which is then adjusted for default risk premium for individuals and organizations based on credit ratings. The forces of demand and supply change on a continuous basis depending on economic conditions and government’s monetary policy and therefore the rate of interest changes over a period of time.