Interest Rates and the Flow of Money
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Interest rate behavior is often an enigma to most people. The same goes for money in general. In this article, we shall find out how money flows and how interest rates are actually determined by the different money-related activities and exchanges that occur day to day.
The Players
Part of the reason it's difficult to understand how money behaves and is projected to behave in the future is that there are so many factors at play and must be considered. As illustrated in the IEA's article, The Circular Flow of Money (Chart 3), we can easily spot several important players and activities associated with money. Money flows to and from the government, households, credit markets, local businesses, and the rest of the world. In all these exchanges, interest is practically inseparable from every form that money takes on.
Factors that Affect Interest
Borrowing and Lending
Often, these exchanges can be narrowed down to two main things: borrowing and lending. And behind each of these is the cost or the reward for borrowing or lending, and that is interest. A borrower must pay an additional cost for having access to money he/she would otherwise not have. A lender takes a risk by deferring spending the money he/she has in the present by gaining an additional amount provided by interest in the future. The difference between the borrowing rate and the lending rate is called interest spread.
Supply and Demand
Another inseparable pair related to interest is the timeless law of supply and demand: in this case, revolving around credit. A general market increase in lending like opening bank accounts, investing in bonds, or signing up for shares increases the supply for what can be lent for potential borrowers. Consequently, since the commodity of credit is less scarce, the cost of obtaining it, which is interest, decreases.
When there is a higher demand for borrowing money than there is a supply for lending it, perhaps due to fewer people paying their dues at the present, the cost of having to borrow, the interest, is pushed up. This occurs not only to the market as whole, but also to your bills if you've failed to keep up with them!
Inflation
Aside from borrowing and lending behavior, inflation also has a lot to do with financial phenomena including interest rates. As inflation rates surge, interest rates increase as well, since lenders expect that the purchasing power of the money they well receive by the time they get it back will decrease.
Tax
Taxes can also affect how interest rates are pegged. If there is a larger portion of earnings/gains that are subject to taxation, interest rates can be increased to compensate for losses.
Profit
Speaking of compensation, it is also likely that an entity such as a bank would add to the total interest rate so that they can gain profit.
Government
Part of the responsibilities of a government, often and more specifically the central bank (in the US, for example, that's Federal Reserve, casually called the Fed), is monetary policy. Monetary policy aims to regulate the economy by controlling a currency's features: the money supply and the interest rate. For example, purchasing more securities provides banks with more money supply, resulting in lower interest rates. Selling securities results in the opposite.
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