Determination of Rate of Interest

Interest rate in an economy is determined by the forces of demand and supply of money in a free market.

The supply of funds is influenced by the willingness of consumers, businesses, and governments to save. The demand for funds reflects the desires of businesses, households, and governments to spend more than they take in as revenues. Normally, interest goes up when businesses decide to invest in plants and machinery and individuals desire to invest in house property, buy vehicles, etc. The interest rate tends to decline during weak economic conditions or the Central Bank of the Country’s attempt to reduce the key policy rates to stimulate housing and other interest-sensitive investments.

The rate of inflation in an economy also affects the movement of interest rates. Interest rates tend to rise when inflation is high, and fall when inflation is falling. This is because interest rates are a tool used by central banks to control inflation. Borrowers have to pay higher rates of interest on their borrowings as the lenders charge higher rates of interest to compensate for the decrease in the value of the money they’ll be paid in the future. 

When inflation is high, governments raise interest rates to discourage people from taking out loans. This is because the cost of goods may increase significantly by the time the loan is paid back.  When interest rates fall, consumers spend more because goods and services are cheaper. This increases demand, which increases prices.

Usually on long-term loans interest rates will be higher than the short-term loans. This is because lenders may face a greater risk of default over a longer repayment period due to economic fluctuations impacting the borrower’s ability to repay the loan, more so there is a chance that the borrower unable to repay due to unforeseen events in the future.  To cover this risk of default lender charge a higher interest rate on their lending to compensate for that risk.

Bonds have an inverse relationship to interest rates. When interest rates rise, bond prices usually fall, and vice-versa.