Interest rates

Interest rates represent the cost of borrowing money or, conversely, the return earned on lending or saving funds over a period of time. They are a fundamental element of the financial system, influencing consumption, investment, savings, inflation, and overall economic activity. In essence, an interest rate expresses the price of money — the compensation paid by a borrower to a lender for the use of funds.

Nature and Definition

In financial terms, an interest rate is the percentage of the principal amount charged or paid as interest over a specified period, typically expressed on an annual basis.
Mathematically:
Interest Rate=InterestPrincipal×100\text{Interest Rate} = \frac{\text{Interest}}{\text{Principal}} \times 100Interest Rate=PrincipalInterest​×100
Interest can be simple or compound:

• Simple Interest (SI): Interest is calculated only on the original principal.

  SI=P×R×T100SI = \frac{P \times R \times T}{100}SI=100P×R×T​

• Compound Interest (CI): Interest is calculated on the principal plus any accumulated interest.

  CI=P(1+R100)T−PCI = P(1 + \frac{R}{100})^T – PCI=P(1+100R​)T−P

Interest rates are central to both microeconomic decisions (such as saving, borrowing, and investing) and macroeconomic policy formulation.

Types of Interest Rates

Interest rates can be classified based on various criteria, including structure, purpose, and market mechanism.

1. Based on Structure

• Nominal Interest Rate: The stated rate without adjustment for inflation.
• Real Interest Rate: The nominal rate adjusted for inflation.

  Real Interest Rate=Nominal Interest Rate−Inflation Rate\text{Real Interest Rate} = \text{Nominal Interest Rate} – \text{Inflation Rate}Real Interest Rate=Nominal Interest Rate−Inflation Rate

2. Based on Lending or Borrowing Purpose

• Deposit Rate: Paid by banks to depositors for keeping money in savings or fixed deposits.
• Lending Rate: Charged by banks and financial institutions on loans to borrowers.
• Policy Rate: Determined by the central bank (e.g. the Reserve Bank of India’s repo rate).

3. Based on Flexibility

• Fixed Interest Rate: Remains constant over the term of the loan or deposit.
• Floating (Variable) Interest Rate: Changes periodically with market benchmarks such as the repo rate, LIBOR, or MIBOR.

4. Based on Risk or Creditworthiness

• Prime Lending Rate (PLR): The minimum rate charged by commercial banks to their most creditworthy customers.
• Sub-Prime Rate: Higher rates charged to borrowers with poor credit ratings, compensating for greater risk.

Determination of Interest Rates

Interest rates are determined by the interaction of demand and supply of loanable funds in the financial system. Various factors influence this equilibrium:

1. Monetary Policy:
   • The central bank regulates key policy rates such as the repo rate, reverse repo rate, and cash reserve ratio (CRR).
   • When policy rates rise, borrowing costs increase, and vice versa.
2. Inflation:
   • Lenders demand higher rates to compensate for the loss of purchasing power caused by inflation.
   • Thus, interest rates and inflation often move in tandem.
3. Economic Growth:
   • During periods of strong economic growth, demand for credit increases, pushing interest rates up.
   • In recessions, lower demand tends to reduce rates.
4. Government Borrowing:
   • Large fiscal deficits and public borrowing can raise interest rates by competing for available funds in the market.
5. Foreign Capital Flows and Exchange Rates:
   • Higher domestic interest rates attract foreign investment, strengthening the currency; lower rates can have the opposite effect.
6. Liquidity Conditions:
   • Abundant liquidity in the banking system lowers short-term rates, while liquidity shortages push them higher.

Key Interest Rates in India

The Reserve Bank of India (RBI) plays a pivotal role in determining and transmitting interest rates in the economy through its monetary policy instruments. Important rates include:

1. Repo Rate:
   • The rate at which the RBI lends short-term funds to commercial banks against securities.
   • A rise in repo rate makes borrowing costlier, discouraging credit expansion.
2. Reverse Repo Rate:
   • The rate at which the RBI borrows from commercial banks.
   • Used to absorb excess liquidity from the banking system.
3. Bank Rate:
   • The long-term lending rate of the RBI to commercial banks; influences the overall cost of credit.
4. Marginal Standing Facility (MSF):
   • Allows banks to borrow overnight funds from the RBI beyond their normal borrowing limit at a slightly higher rate than the repo rate.
5. Cash Reserve Ratio (CRR):
   • The proportion of deposits banks must maintain as reserves with the RBI. A higher CRR reduces lending capacity.
6. Statutory Liquidity Ratio (SLR):
   • The proportion of deposits to be invested in government securities.
7. Base Rate / MCLR (Marginal Cost of Funds-based Lending Rate):
   • The minimum rate below which banks cannot lend; ensures transparency in the pricing of loans.

Relationship between Interest Rates and the Economy

Interest rates are one of the most powerful tools for regulating macroeconomic activity.

• High Interest Rates:
  • Discourage borrowing and spending.
  • Control inflation but may slow economic growth and investment.
• Low Interest Rates:
  • Encourage borrowing and investment.
  • Stimulate economic growth but may fuel inflation or asset bubbles.

Transmission Mechanism:

Changes in the central bank’s policy rate affect the overall economy through multiple channels:

• Credit Channel: Alters borrowing costs for households and firms.
• Exchange Rate Channel: Influences capital flows and currency valuation.
• Expectations Channel: Shapes inflation and growth expectations.

Theories Explaining Interest Rate Determination

Several economic theories attempt to explain how interest rates are set:

1. Classical Theory:
   • Interest is determined by the supply of savings and demand for investment.
2. Loanable Funds Theory:
   • Expands the classical view by including other factors such as bank credit, dis-saving, and government borrowing.
3. Liquidity Preference Theory (Keynes):
   • Interest rate is the reward for parting with liquidity; determined by the demand and supply of money.
4. Fisher’s Theory:
   • Distinguishes between nominal and real interest rates; links the two through the expected inflation rate.

Interest Rate Differentials and Global Linkages

In a globalised economy, interest rates are influenced by international capital movements.

• Higher interest rates in one country attract foreign investment, leading to currency appreciation.
• Central banks often monitor interest rate differentials to maintain exchange rate stability and manage external balances.

Contemporary Trends

In recent years, global interest rate patterns have been influenced by:

• Quantitative easing and ultra-low policy rates in advanced economies following the 2008 financial crisis.
• Inflation resurgence and monetary tightening cycles after the COVID-19 pandemic.
• Shift from LIBOR to alternative benchmarks such as SOFR, as part of global financial reforms.
• Digital lending and fintech innovations introducing new interest models in credit markets.

Importance of Interest Rates

Interest rates serve as a vital link between monetary policy, financial markets, and the real economy. Their significance includes:

• Guiding investment and consumption decisions.
• Influencing inflation, savings, and exchange rates.
• Reflecting the overall health of the economy.
• Acting as a key tool for macroeconomic stabilisation.