Some of the key factors that affect interest rates are:
1. Inflation: Inflation refers to the general increase in the price level of goods and services. High inflation rates usually lead to higher interest rates as lenders demand compensation for the decrease in purchasing power of their money.
2. Supply and demand of credit: The availability of credit supply and demand also affects interest rates. When the demand for borrowing is high, lenders may increase the interest rates to discourage borrowers from accessing more credit. Conversely, when the supply of credit is high, interest rates may decrease as lenders try to attract borrowers and remain competitive.
3. Monetary policy: Central banks use monetary policy tools to control the money supply in the economy. By increasing or decreasing the supply of money, they can influence interest rates. For example, when a central bank lowers its interest rates, it makes borrowing cheaper and stimulates economic growth. On the other hand, when it raises interest rates, it discourages borrowing and spending, thereby reducing inflation.
4. Risk and uncertainty: Higher levels of risk and uncertainty can increase interest rates. For example, lenders may increase interest rates on loans to small businesses or start-ups as they perceive these to be riskier lending propositions.
The impact of interest rates on the economy is significant. Higher interest rates can lead to lower borrowing levels and lower spending, thereby slowing down economic growth. Lower interest rates encourage borrowing, spending, and investment, resulting in an increase in economic activity. Interest rates also influence the value of currencies, which can have an impact on international trade and economic activity.
