Like any other commodity available in a market, to avail money we have to pay price. The price is known as interest rate. For lenders, interest is the income earned for lending money to the borrowers which could either be financial institutions like Banks or directly to an individual. For a person borrowing, interest is the extra amount that is paid to lending institutions for borrowing money from them.
Why Interest is charged? There are many possible reasons for the interest charged on the money lent like:
- Purchasing Power of the Money: Due to inflation purchasing power of money would decrease with time and lender should be compensated for the decline in purchasing power of money.
- Risk of not paying back: With every loan, there is a possibility that the borrower will not repay the money. To compensate lenders for that risk, there must be a reward:
- Opportunity Cost: During the period of loan, lender could have used money to earn some income and accordingly lender should be compensated for lost opportunity to earn some extra income.
Effects of Interest rate on Consumer/Bank spending:
Central banks (RBI in case of India), uses interest rate as a tool to control the price stability or inflation within economy. The rate of interest that is offered by financial institutions affects peoples’ decisions on whether to save or spend their money.
Usually, when interest rates are high people tend to save or deposit more of their money. By doing so, consumers are postponing their current spending to a later date i.e. keeping money aside for future spending. Additionally, when interest rates are elevated, people tend to borrow less since it costs more to take out loans today and means lower spending in the future when the loans fall due. Businesses operate the same way, as higher interest rates will raise their business costs and reduce the incentive for borrowing.
Conversely, if interest rates are low, individuals and businesses save less as their return on deposits will be low. They are likely to borrow more as the cost of borrowing is cheaper. Consequently, there will be more spending that will boost economic activity.
Effects of Interest rate on Inflation or Economic Growth:
The change in interest rate by central bank impacts inflation or economic growth as interest charged by bank decides the availability of money within economy.
Inflation refers to the rise in the price of goods and services over time. It is the result of a strong and healthy economy. However, if inflation is left unchecked, it can lead to a significant loss of purchasing power.
The Central Bank usually increases interest rates when inflation is predicted to rise above their inflation target. Higher interest rates tend to moderate economic growth. They increase the cost of borrowing, reduce disposable income and therefore limit the growth in consumer spending. Higher interest rates tend to reduce the rate of economic growth and inflationary pressures.
Conversely, when central banks decreases the interest rate borrowing money becomes cheaper; this entices people to start spending again.
Interest rates have various economic effects:
- Increases the cost of borrowing. With higher interest rates, interest payments on credit cards and loans are more expensive. Therefore this discourages people from borrowing and spending.
- Increase in the mortgage interest payments. Related to the first point is the fact that interest payments on variable mortgages will increase. This will have a significant impact on consumer spending.
- Increased incentive to save rather than spend:Higher interest rates make it more attractive to save in a deposit account because of the interest gained.
- Government debt interest payments increase: Higher interest rates increase the cost of government interest payments. This could lead to higher taxes in the future.
There are several other rates which a central bank could use as monetary policy to impact the liquidity within the economy.
- Cash Reserve Ratio: Cash Reserve Ratio is a certain percentage of bank depositswhich banks are required to keep with RBI in the form of reserves or balances. Higher the CRR with the RBI lower will be the liquidity in the system and vice versa.
- Statutory Liquidity Ratio: Every financial institution has to maintain a certain quantity of liquid assets with themselves at any point of time of their total time and demand liabilities. These assets have to be kept in non-cash form such as G-secs precious metals, approved securities like bonds etc.
- Repo Rate and Reverse Repo Rate: Repo rate is the rate at which RBI lends to its clients generally against government securities. Reduction in Repo rate helps the commercial banks to get money at a cheaper rate and increase in Repo rate discourages the commercial banks to get money as the rate increases and becomes expensive. Reverse Repo rate is the rate at which RBI borrows money from the commercial banks.