Infernal Ramblings
A Malaysian Perspective on Politics, Society and Economics

The Power of Interest Rates

Written by johnleemk on 2:58:57 pm Jun 2, 2007.

Interest rates are one of the lesser-understood aspects of the economy. We may read about a central bank's decision to increase or decrease rates in the finance section of the papers, but we do not understood why it is so important.

To understand the impact of interest rates on the economy, we have to realise something about the interest rates we see everyday. As I've explained in the past, we are paid interest on our savings; this interest comes from the interest of debtors who owe our bank money.

Why do people take out credit? The main reason for businesses is so they can start or participate in a venture which will yield a rate of return greater than the rate of interest they must pay on the loan.

For many consumers, however, a loan exists for them to defer payment on a good or service. They are able to buy a house or car with money they do not have, in exchange for a promise to pay some greater amount of money in the future.

It thus follows that the interest rate is actually the price of money. You might be lost at this, but think about it. When you loan your money to someone, you are selling that money to him in return for a promise to repay the same sum in the future, along with interest — the interest is the price he pays for that money.

Once we realise that the rate of interest is an expression of the price of money, we can apply the usual laws of supply and demand to money. When the interest rates are high, the demand for money is low, and the supply is high. People will not be interested in borrowing much, but they will be interested in loaning out the money because of the high price they can get for it. When interest rates are low, the exact opposite occurs.

A corollary of this is that the economy will grow when interest rates are low, and will shrink when interest rates are high. The reason for this is simple — when few people want to borrow money, then there will be less investment (firms will prefer to save their money in the bank, rather than take out a loan and invest it), and also less consumption (individuals will wait for rates to drop before taking out a new mortgage).

When you introduce another variable into the equation — foreign exchange — things get even more interesting. If a central bank wants to strengthen its currency, all it has to do is raise the interest rate — foreign investors will store their money in the country, and the exchange rate will strengthen accordingly. To achieve a weakened currency, the central bank just has to reduce rates.

Of course, this puts to paid the myth that a strong exchange rate reflects a strong economy; the exact opposite can occur depending on how the interest rates are manipulated.

Another realisation that follows is that if the government wants to fix the exchange rate, it will find it difficult to control the rate of economic growth. If the government wants a strong exchange rate, it has to put a lid on growth by raising interest rates; if it wants a weak exchange rate (which can be desirable, because it makes the country's exports cheaper), it cannot restrain the economy if it overheats.

When economists at your country's central bank or monetary authority change the interest rate, you may not realise its effects immediately. But at least now you will know why financiers and businessmen are so interested in any sign of rate changes.

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Infernal Ramblings is a Malaysian website focusing on current events and sociopolitical issues. Its articles run the gamut from economics to society to education.

Infernal Ramblings is run by John Lee. For more, see the About section. If you have any questions or comments, do drop him a line.

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