I understand what an interest is when someone takes a loan but in the broader sense, when we talk about a nation’s interest rate, what does that mean?
I understand what an interest is when someone takes a loan but in the broader sense, when we talk about a nation’s interest rate, what does that mean?
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It’s the benchmark rate from which all other rates are derived. So your credit card loan, home loan, personal loan, are all based on what the nation’s interest rate is. So the lower the nation’s rate, the lower your loan rates will be, and vice versa.
Imagine interest rates are like the thermostat for the economy. If things are too hot (prices rising too fast), the country turns the temp down by raising rates—makes borrowing harder so people spend less. If things are too cold (people not spending), they lower the rates to warm things up. It’s basically economic climate control.
Interest rates are the cost of borrowing money, in the case of governments, they are setting the rates for something like the federal reserve.
If the government sets a low interest rate, then it becomes cheap to borrow money as banks and other institutions will also lower their private interest rates.
This tends to lead to more borrowing and more spending, sometimes causing inflation. Raising interest rates disincentivises borrowing and spending, naturally. This can help slow down inflation as people spend less and prices of goods and assets don’t rise as fast.
How to balance that is a much more complex question, but that’s what it is and why it matters
If I wanted to give you 1 million dollars, the government would consider that a wealth transfer and would tax you for it. If I said I would loan you 1 million dollars and charge 0% interest in perpetuity, this wouldn’t be considered a wealth transfer, because it’s still my money, but you would never have to pay it back. To prevent this loophole, the government sets a limit on how much money that I can give you as a gift or a political donation or whatever, without charging you interest. Beyond this amount, the government sets a minimum interest rate that I have to charge you so that the money that you receive is not taxable on your end (I still have to pay taxes on the interest that I receive).
The government changes this rate periodically depending on whether they want more people to borrow money or not.
Countries have institutions called central banks. The job of the central bank is to try to help push economic growth while managing two competing forces in the market; 1) unemployment, and 2) inflation.
Generally, if inflation is very low and unemployment is very high, the economy slows down to recession. While if inflation is very high and unemployment is very low, the economy overheats. The central bank wants to find a sweet spot where neither number is too high or too low, because that’s when economic growth is the most reliable and strong.
One of the things that strongly influences unemployment and inflation is when companies take out loans. A business that wants to double in size and hire a lot more people usually takes out a loan to do it. And, all of those people with their new jobs and salaries spend money, which increases demand and drives up prices.
If too many businesses are taking out too many loans, the economy will overheat and inflation will go crazy. If too few businesses are taking out loans, it means companies aren’t taking risks to go after good business opportunities, so the economy slows.
So if a central bank wants more or less loans to happen, they try to either increase or decrease how much business want to take out loans. They do this by making loans more expensive (fewer people want to borrow money when costs are high), or making them cheaper (easy money means more people are willing to take a chance). They make loans more or less expensive by trying to control the interest rate of those loans, by raising them or lowering them.
So when economies are sluggish, they might lower rates to spur more borrowing and create growth. And when economies are moving too fast, they might raise rates to reduce borrowing and slow things down.
Banks would offer outrageous interest rates and desperate people would take them or be tricked into them, and then default and cause the loan to collapse. It made lending a total mess and religions even had laws around these crazy interest rates, called usury. Banks really only work in good faith, where people do what they say they’re going to do. And governments have a public interest in making sure banks don’t do stupid things. And they will do stupid things, if you let them.
But governments also found regulating this interest amount to be really useful to encourage or discourage spending, which gave them an effective tool to manage inflation. If you have deflation, people stop spending money. It just makes sense to wait til your money becomes more valuable, but no buying means nobody can make a sale and so everyone starves. If you have too much inflation, people can’t save money, as it keeps losing value before you’re ready to spend it.
Interest rates make it easier or harder to get access to loans so you can make big purchases, which can alter inflation. So the government sets the rate, to have some control over the nation’s economic well-being.
There isn’t any single national interest rate for any country, but all interest rates in an economy tend to move in the same directions together. Governments borrow money from other governments and private actors to finance their programs. They do this by selling bonds for varying lengths of time. In order to sell those bonds they have to offer interest rates that the buyers find acceptable. In general, the higher the chance buyers think there is for a bond to not be paid off, the higher the interest rate they will demand and the less they will be willing to lend at any given interest rate. The inverse is true – the more reliable a bond is considered, the less interest buyers will demand. These principles are also true for every other kind of debt. Through the buying and selling of US Treasury bonds, in addition to the setting of reserve ratios and the rate at which banks can borrow from it as a last resort The Federal Reserve – America’s central bank – attempts to influence interest rates throughout the economy to maintain stability and growth. So there is no single interest rate, but there are key interest rates like the federal funds rate – at which banks borrow from each other, and the going interest rates for different Treasury bonds which influence other interest rates like what you may be charged for a car loan or mortgage.