The Effect of Interest Rate on the Economy
Interest rate – is one of the significant fundamentals of economy which provides a background of the level of economic activity that is present in a given country, specifically in the financial market. Theoretically, interest rate is considered as a payment or cost of borrowed money or capital (e.g. stock, bonds, consumer goods, shares, etc) (CIBC Wood Dundy, 2008). Interest rate stands as compensation to the lender for foregoing valuable investments, opportunity cost, that he/she could have been made with the loaned money. If borrowers treat interest rate as cost or “rent on money”, lenders see interest rate as an income from lending a principal amount to a borrower while shouldering various types of risks.
One may not directly see the impacts of interest rate in the economy, but it plays a significant role that can either make or break the economy of a particular country. The following are the impacts that can be derived from using interest rate as one of the fundamental factors of the economy:
· Interest rates can provide the government a means of controlling the volume of money circulating in the economy. The central bank raises interest rate if they want to lower the volume of money circulating in the economy and cut the interest rate if otherwise. By increasing the interest rate, the central bank can discourage different types of bank from borrowing to them, thus, banks in the financial system will only have a limited supply of money to dispose to their depositors incase the latter withdraw money. On the other hand, if the government feels that they have to raise the supply of money circulating in the economy, then, they tend to lower interest rate to encourage banks and other financial institution to borrow money to them. This will raise the amount of money present in the vaults of financial institutions that are ready to be distributed to their depositors.
· Interest rate provides income to various financial institutions in the economy (e.g. banks, lending firms, central bank, etc) in the form of “rent money” which borrowers have to pay along with the principal amount. The “rent money” is the compensation received by lenders for exposing their capital from various forms of risks (loan default, market failure, etc.) which can jeopardize the real value of his/her capital. Lenders always face opportunity cost from lending their money to financially incapable people instead of investing it to other favorable financial market and the opportunity cost must be paid in the form of interest rate. On the other hand, the government generates income from lending money through the central bank which is then used to finance its projects and programs (Amadeo, 2008). Borrowers on the other hand, get additional financial obligation to the lender aside from the principal money that he/she borrowed.
· Interest rate can also be used by the government to provide financial assistance (monetary policy) to various sectors of the economy by lowering the interest rate during economic crisis/recession. Business firms find it discouraging to apply for a loan given that they have to pay for high interest rate considering their financial instability. Thus, lowering the interest rate would lessen the cost that these firms will face after the maturity period of their loan. This scenario seems to be happening at present times as real estate firms and lending firms needs to borrow funds to refinance their operations. The Federal Reserve already cut their interest rate to give enough room for financially unstable business to borrow money from them (Wyplosz, 2007). It is being expected that the lowering of interest rate of the Federal Reserve will gradually make the country recover from its economic slowdown through aiding the private sector through providing them an easier access to loans to continue their operations.
· Interest rate can also attract foreign investors in the country. Providing low interest rate would give foreign investors an incentive to invest here in the country since this policy will make the borrowing of capital cheaper relative to other countries. Foreign Direct Investment is expected to grow once the government implements the offering of lower interest rate to foreign investors that will capitalize here in the country. On the other hand, the government can also use interest rate to discourage the entry of foreign investors to their economy by offering high interest rate and to protect the interest of the domestic industry.
· Interest rate can also influence the level of inflation rate that is present in a given country. It is said that interest rate can either curb or worsen the condition of inflation rate. Low interest rates stimulate the economy and result to an increase in economic activity as well as the cost of living and price of goods in the market. Thus, low interest rates results to the rising of inflation rate through the level of economic activity. On the other hand, high interest rate can slowdown the economic activity in the country by enabling firms borrow less money from banks and other financial institutions. Businesses firms are left with no choice but to lower the prices of their products to attract more customers and gain more profit. Thus, uplifting the interest rate will lead to lower inflation rate.
Though interest rate can be influenced by the government, it is the responsibility of the latter to ensure that the interest rate they will implement provides social and economic welfare improvement. Meaning, the optimal level of interest rate must be applied in the economy to ensure the attainment of economic growth. The equilibrium level of interest rate, at the end of the day, must provide the economy with welfare improvement both in the private and public sector.
Amadeo, K. (2008). A Primer on the Role of Interest Rate in the Economy. Retrieved October 7, 2008, from http://useconomy.about.com/od/interestrateindicators/p/interest_rate.htm
CIBC Wood Dundy (2008). The Importance of Interest Rates. Retrieved October 7, 2008, from https://www.woodgundy.com/wg/en/reference-library/topics/investment-solutions/fi-rates.jsp
Wyplosz, C. (2007). While the ECB ponders, the Fed moves, and cleverly at that. Retrieved October 7, 2008, from http://www.voxeu.org/index.php?q=node/479