Whether you like it or not, interest rates play an important role in our lives. Just like rivers in the ancient world, interest rates in modern times determine the flow of trade and commerce. They also affect major events of our life, such as when we plan to purchase a car or house, or decide to go abroad to study. Our friend Johnny wonders what makes interest rates so powerful. To know the answer, he needs to understand how interest rates really work. Maybe Jinny will help him find the answers today.
Johnny: Hi, Jinny. Finding someone taking interest in others’ interest is really a tough job these days. I am lucky that you are always around.
Jinny: Well, you can stop trying to flatter me, and come straight to the point.
Johnny: I was just wondering who the master of the universe is these days. Is it George or Gordon or Vladimir?
Jinny: If you ask me, I would say interest rates are the masters of the universe these days. The have the power to shake the lives of not only bond traders, but also tomb raiders. They can put George down or make Gordon frown—such is their power. If you are interested, I can tell you in detail how interest rates really work.
Johnny: I am always interested. You can go ahead without asking.
Jinny: Let’s start with the basics. Money is one of the most important factors that enable you to acquire not only the basic necessities, but also exotic luxuries. You can buy vegetables or a penthouse or even a new company depending upon how much money there is in your pocket. But this money in your pocket need not necessarily be yours. The modern world runs on borrowed money. But where does this borrowed money come from? Well, there are many people who are interested in buying neither vegetables nor penthouses at present. They want to save money for the future. At this point, someone like me appears and requests them to lend me their surplus money, so that I can put it to some use. I promise to return the money after some time, which sounds credible. But then the lender may ask what benefits he will get by lending the money. I promise to pay a “rent” for lending me the money. I say, tomorrow, I will return more money than what I am borrowing from you today. This “rent” for borrowing or lending money is what we know as interest rates in financial terms.
Johnny: But, I fail to understand how such a simple thing as interest rates can rule the world.
Jinny: You can divide the world into two broad categories: borrowers and lenders. Those who are neither borrowers nor lenders must still be living in a primitive age. There could be different kinds of borrowers—right from a small farmer looking for microcredit to a business tycoon looking for money for his mega project. Even governments borrow to meet their deficit. Similarly, lenders could also be of different shapes and sizes, right from a housewife saving money from her monthly expenses to a high net worth individual owning his private jet.
Interest rates affect both borrowers and lenders. Borrowers want lower interest rates, whereas lenders want higher interest rates. What rates ultimately prevail is decided by a host of factors.
Johnny: What factors ultimately decide interest rates?
Jinny: There are many interwoven factors that influence interest rates. In the first place, interest rates—like the price of any other commodity —are affected by demand and supply. If the demand for borrowing money is more than the supply, the interest rates will rise. But there are many factors that influence demand and supply themselves. For instance, short-term interest rates, which may act as a benchmark for long-term interest rates, are set by the central bank. While setting the short-term interest rates, the central bank takes note of many factors, such as the outlook on inflation and growth. In case inflation is rising, the central bank hikes the short-term interest rates to control money supply. Inflation or rise in prices erodes the purchasing power of a currency. So, if you can purchase a dozen eggs today for Rs100, you may be able to purchase only half-a-dozen after five years due to the rise in prices. So, anybody lending Rs100 today, would expect a return of, at least, Rs200 in the next five years to offset the fall in the purchasing power of currency.
However, demand and supply are not the only factors affecting long-term interest rates. A lender is also likely to take note of the risk in lending his capital for a longer period. As a general rule, the higher the risk, the higher the interest rate.
Johnny: Well, Jinny, you have tried to explain everything in a few words, which could very well be a subject matter of a long discussion. I have a few questions regarding the role of the central bank in the whole process. I’ll bother you with that later.
What: Interest rates are the cost of money paid by the borrower to the lender.
Why: Interest rates are paid to the lender to compensate for the loss of opportunity and risk of default.
How: Interest rates are determined by a host of factors like demand and supply of money, inflation and risk premium, among others.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org