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Focus Question: How do interest rates act as incentive for savers and borrowers?
Play Poster for "The War of Wealth," 1895
Topics on the Page
What is Interest?
Interest Rates
Compound vs. Simple Interest
Rise and Decline in Interest Rates
Who Controls the Interest Rate
How Interest Rates Affect You
Page Summary
Interest rates are the price of money, which borrowers pay to lenders for the use of their money. Savers earn interest on their savings as a reward for lending their money to the borrower. Interest rates affect both savers and borrowers directly. If interest rates rise, savers may be more motivated to save money as they will earn higher returns on their savings. On the other hand, borrowers may be discouraged from taking out loans or may reduce the amount they borrow due to the higher cost of borrowing. Overall, interest rates have a significant impact on the decisions of both savers and borrowers, which in turn affects the overall health of the community. In a perfect world, the best situation for both savers and borrowers would be a healthy, growing economy with low and stable inflation. Callie Sullivan (May 2023)
What is Interest?
A simple and informative video on interest rates and their function.
The cost of borrowing, which compensates lenders for the RISK they take in making their money available to borrowers.
Without interest there would be little lending and thus a lot less economic activity.
Some American states also have usury laws, imposing tough conditions on the terms set by lenders, although not actually prohibiting interest. Yet, as the recent rise of a substantial banking industry in Islamic Middle Eastern countries shows, when economic growth is a priority, ways can usually be found to pay lenders to lend.
Interest is usually expressed at an annual rate: the amount of interest that would be paid during a year divided by the amount of money loaned.
Developed economies offer many different interest rates, reflecting the length of the loan and the riskiness and wealth of the borrower.
People often use the term “interest rate” when they mean the short-term interest rate charged to banks. For instance, when a central bank raises or cuts interest rates, it changes only the price it charges to banks borrowing money overnight, expressed as an annual rate.
Bond yields are a better measure of the interest rate on loans that do not have to be repaid for many years.
Unlike short-term interest rates, bond yields are determined not by central bankers but by the supply and demand for money, which is heavily influenced by the expected rate of inflation.
This holds true because of liquidity.
When interest rates are low, borrowers are at an advantage and there is a higher flow of hard cash; when interest rates go up, it becomes more advantageous to hold money in the form of bonds to get a greater return, and thus liquidity goes down.
The specific effects of inflation and deflation are mixed and fluctuate over time.
Deflation is typically caused by depressed economic output and unemployment. Lower prices may eventually encourage improvements in consumption, investment, and foreign trade, but only if the fundamental causes of the original deterioration are corrected.
Inflation initially increases business profits, as wages and other costs lag behind price increases, leading to more capital investment and payments of dividends and interest.
Personal spending may increase because of “buy now, it will cost more later” attitudes; potential real estate price appreciation may attract buyers.
Domestic inflation may temporarily improve the balance of trade if the same volume of exports can be sold at higher prices.
Government spending rises because many programs are explicitly, or informally, indexed to inflation rates to preserve the real value of government services and transfers of income. Officials may also anticipate paying larger budgets with tax revenues from inflated incomes.
For a short video with a clear explanation of Inflation, go here.
Who Controls the Interest Rates?
The Federal Reserve System, often referred to as the Federal Reserve or simply "the Fed," is the central bank of the United States.
In 1977, Congress gave the Fed two main tasks: Keep the prices of things Americans buy stable, and create labor-market conditions that provide jobs for all the people who want them.
The Federal Reserve adjusts the interest rates that banks charge to borrow from one another, a cost that is passed on to consumers.
The Fed raises rates in a strong economy to keep excesses in check, and cuts borrowing costs when the economy needs support.
The banking system controls their own interest rates, but they are based off the Federal Funds Rate.
Interest rates are a part of everyday life. There is an interest rate on your credit card. Most people have a mortgage which has an interest rate. Your savings account has an interest rate. What does this mean for you?
Many people have the question 'When should I save my money and when should I borrow money?'
When interest rates are low you should borrow money.
This is due to the fact that when you have to repay this loan it will cost less money.
When interest rates are high you should save money.
This is due to the fact that when interest rates are high you can make more of a return on your money when its in a savings account.
However monetary policy is not as easy as it sounds and there is not a definite answer for every situation.
Ultimately the best situation for both savers and borrowers is a healthy, growing economy with low and stable inflation
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