Factors Influencing Interest Rates

Factors Influencing Interest Rates

An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. Banks or lending institutions usually have general guidelines for the rate they intend to charge. Money lent by the bank on short term basis or long term basis has different interest rate. Here we focus on the macro interest rates in the general economy, and discuss what factors may Influence interest rates. There are factors that influence the level of market interest rates: Supply and Demand for Funds

Interest rates are the price for borrowing money. Interest rates move up and down,

reflecting many factors. The most important among these is the supply of funds, available for loans from lenders, and the demand, from borrowers. If the demand for borrowing is higher than the funds, the banks can raise their rates or borrow money from other people by issuing bonds to institutions in the wholesale market. The trouble is, this source of

funds is more expensive. Therefore interest rates go up. If the banks and trust companies have lots of money to lend and the housing market is slow, any borrower financing a

house will get special rate discount and the lenders will be very competitive, keeping rates low.

The average rate of profit

In market economy, the interest is a part of the average profit. Consequently, interest rates are also determined by the average rate of profit. The function of restriction can be summarized that the general level of interest rates should adapt to the affordability of most enterprises. That is to say, on one hand, the general level of interest rates cannot be too high to burden the enterprises; on the other hand, the general level of interest rates also cannot be too low that they can't play the role of leverage. Monetary Policy

One of the government’s strategies to control the flow of money within its consumers is by monetary policy. People will avoid borrowing money when the interest rates are high. This in turn will reduce the money outflow and affect the country’s revenue as consumers will not be spending unless it is necessary. In order to stimulate growth, government may offer lower interest rates on borrowing which subsequently attracts consumer to spend more borrowing. However, when the growth rate increases rapidly to the extent that economy may face overheat problem, the government then have to curb this by imposing higher interest rates. The rate of inflation

The rate of inflation is another important factor that governs interest rates on loans. Over time, as the cost of products and services increase, the value of money decreases. Consumer will therefore have to spend more money for the same products or services which had cost less in the previous year. The value of money now has fallen as compared to the time when they lent their money. In order to compensate this loss, lenders have to increase the interest rate. On the other hand, a drop in the rate of inflation indicates a softer interest rate regime. General economic conditions

Economic conditions may face series its booms and slumps. The world economy has been on the slump side in the past few years with many business closures. Banks are unable to provide loan at lower rate as they have to cover their cost. As a result, interest rates fluctuate with global economic condition.

Apart from the above, other factors such as political and financial stability, investors’ demand for debt securities, risks of investment and taxes also affect interest rates.