Part I: What is an interest rate? Who decides it? How is it used?

When discussing anything related to economics or finance, talk of interest rates is never far away. For good reason. Interest rates, while not exactly the most captivating topic of conversation, have an enormous impact on the world of money. To those whose careers and lives revolve around the topic, interest rates and their effects are well understood. To those not so well versed, such talk can be confusing and difficult to get a grasp on. The point of this article is to help readers who are not completely immersed in such affairs.

What is an interest rate? Simply put, an interest rate defines the cost of borrowing money. Conversely, it defines the benefit gained from lending it out.

Why should borrowing money cost anything? Because lending money incurs a certain risk. There is a risk the borrower will not pay the money back. There is a risk the party lending the money will lose it. The interest serves as compensation for taking on that risk. Fundamentally, the interest rate is the price of using money you do not own.

At the lower echelons of finance, this definition serves us well. It makes sense in the context of an agreement between individuals, banks or other institutions of lending. It makes sense with regards to a loan or mortgage or car payment. But we have to go bigger.

Who decides the interest rate? Outside of the realm of personal finance, “interest rate” takes on a bigger, more encompassing meaning. Interest rates, at the scale of a sovereign nation, are the responsibility of that country’s central bank. This “national” interest rate, so to speak, serves as the baseline from which banks then lend out money to individuals or businesses.

Why does the central bank need to tell everyone what the interest rate is? Because the main remit of a central bank is to maintain the monetary and financial stability of the country’s currency. Put another way, the central bank’s role is to stop the money becoming too weak or too strong. Controlling interest rates is the main way of achieving this.

How does it work? Let us consider two different scenarios. The first is that interest rates are low. Money is very cheap to borrow - a situation called monetary easing. If investors can borrow money for cheap and use it to buy assets that are greatly increasing in value, why would they not? After all, whatever profit they make on their investments will easily cover the interest payments on the loan. Easy money. The costs of borrowing money are not just limited to investments either. If a company can borrow money cheaply and then use it to expand and hire more people, this has a very obvious positive impact on the economy as a whole. This is why a central bank will typically lower interest rates in order to stimulate growth.

As with most things, there is a catch. Per design, low interest rates make money more accessible, which is coupled with a greater money supply. Simple supply and demand dynamics dictate that if the supply goes up then the price goes down. Essentially, the money becomes less valuable because there is more of it. If the money is worth less, it follows that people will want to ask for more of it, in order to maintain the same level of compensation. This is called inflation.

The second scenario is the exact opposite: interest rates are high. Money is now very expensive to borrow - a situation known as monetary tightening. The cost of borrowing money now prohibits investors from taking on too much debt, resulting in them sitting on large piles of cash instead. Since interest rates are high, that cash is actually earing them a solid income anyway. Why bother with risky investments when you’re earning an extremely safe 5% interest?

Once again, there is a catch. As opposed to the earlier situation, high interest rates are coupled with a reduction of the money supply. This time, supply and demand dynamics dictate that if the supply goes down then the price goes up. The money becomes more valuable because there is less of it. This is called deflation.

On the face of it, this doesn’t seem like a problem at all. The money is worth more, people can buy more with the same amount of cash. Win-win surely? Unfortunately, things aren’t so simple. The reduction in money supply can lead to a reduction in investment, which can in turn lead to a reduction in growth, which can lead to a stagnating or even shrinking economy. One analogy that might help here is that of an aircraft stalling due to a lack of airflow over the wings.

The above paragraph serves to help the reader understand the more traditional view of deflation. Such a view is in fact entirely challengeable, particularly if one were to adopt the stance that economic growth is not the absolute measure of a country’s merit, nor that of its people. A debate for another day.

We begin to see a balancing act emerge. Too low interest rates and we have inflation, too high and we have stagnation. The role of the central bank is to find the sweet spot to ensure both monetary stability and economic growth. Simple things like the price of goods and jobs numbers are the main metrics by which it gauges these. In part two of this article, we will look more deeply into the tools a central bank has at its disposal. We will also look into the global interactions that result from competing international currencies and their respective rates.