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MEANING OF INTEREST RATE An interest rate is the rate at which interest is paid by borrowers for the use of money

that they borrow from a lender. Specifically, the interest rate (I/m) is a percent of principal (P) paid a certain amount of times (m) per period (usually quoted per annum). For example, a small company borrows capital from a bank to buy new assets for its business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest rates are normally expressed as a percentage of the principal for a period of one year. Interest-rate targets are a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment.

WHO DETERMINES INTEREST RATES? In countries using a centralized banking model, interest rates are determined by the central bank. In the first step of interest rate determination, the government's economic observers create a policy that helps ensure stable prices and liquidity for the country. This policy is routinely checked to ensure that the supply of money within the economy is neither too large (causing prices to increase) nor too small (causing prices to decrease).

Because retail banks are usually the first financial institutions to expose money to the economy, they are the principal instruments used by the central bank to manipulate the money supply. By adjusting the interest rates on the money it lends to or borrows from the retail banks, the central bank is able to regulate the supply of money to the end user.

If the monetary policy makers wish to decrease the money supply, they will increase the interest rate, making it more attractive to deposit funds and reduce borrowing from the central bank. On the other hand, if the directors wish to increase the money supply, they will decrease the interest rate, which makes it more attractive to borrow and spend money. REASONS FOR INTEREST RATE CHANGE

Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on interest rates.

Deferred consumption: When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.

Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.

Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.

Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.

HOW DO INTEREST RATE CHANGES AFFECT THE ECONOMY? As the central bank raises or lowers short-term interest rates, banks may raise or lower the interest rates they charge borrowers, including the prime rate. Changes in the prime rate may affect:

Individually. Banks use the prime rate to set rates for credit cards and consumer loans. If you have an adjustable-rate mortgage or a credit card that has a rate tied to the prime rate, payments may rise or fall according to the prime rate. The whole economy. A change in the prime rate may affect the overall economy in several ways. For example, an increase may result in fewer consumers taking auto loans, which in turn may cause a slowdown in the automobile industry. On the other hand, when interest rates fall, businesses find it easier to finance expansion and other activities. Typically, increases in interest rates slow economic growth because consumers have less money to spend and less motivation to borrow. Conversely, if interest rates drop, the economy may benefit from increased spending.

o The economy can be influenced easily by interest rates. When interest rates are high, people do not want to take loans out from the bank because it is more difficult to pay the loans back, and the number of purchases of cars and homes goes down. The opposite is also true. o The effects of a lower interest rate on the economy are very beneficial for the consumer. When interest rates are low, people are more likely to take loans out of the bank in order to pay for things like houses and cars. When the market for those things gets strong, price decreases and more people can purchases these things. This also bodes well for investors, who perceive less risk in taking out a loan and investing it in something because they would have to pay less back to the bank. o When people do not have to spend as much money on bank payments, they have more disposable income to put toward things they want to purchase. Suddenly, a trip to the ice cream store is not so much of a budget crunch and a weekend at the spa seems more doable. These effects, although certainly not direct, are enough to stimulate the market when interest rates are low. o Low interest rates are not beneficial for lenders, who are seeing less of a return on their loan than in times when interest rates are high. This means that banks may find themselves having to lower the interest rates accrued on money deposited in the bank in order to maintain a steady profit. However, interest rates do not really have an effect on how much people save, because an increased amount of disposable income means that they are more likely to spend it than to save it. o When interest rates increase, though, foreign investment can increase because people outside of the country want a larger return for their investment and they are more likely to get it in a state of high interest rates. This causes more demand for the dollar, driving up its value in the international market. The opposite happens, though, when the interest rates are decreased. EFFECT OF RISING INTEREST RATES Higher interest rates have various economic effects:

1. Increases the cost of borrowing. Interest payments on credit cards and loans are more expensive. Therefore this discourages people from borrowing and saving. People who already have loans will have less disposable income because they spend more on interest payments. Therefore other areas of consumption will fall. 2. Increase in mortgage interest payments. Related to the first point is the fact that interest payments on variable mortgages will increase. This will have a big impact on consumer spending. This is because a 0. 5% increase in interest rates can increase the cost of an Rs.100, 000 mortgages by Rs.60 per month. This is a significant impact on personal disposable income. 3. Increased incentive to save rather than spend. Higher interest rates make it more attractive to save in a deposit account because of the interest gained. 4. Rising interest rates affect both consumers and firms. Therefore the economy is likely to experience falls in consumption and investment. 5. Reduced Confidence. Interest rates have an effect on consumer and business confidence. A rise in interest rates discourages investment; it makes firms and consumers less willing to take out risky investments and purchases.

EFFECT OF LOWER INTEREST RATES If the Central Bank reduces the base interest rate, this will usually cause commercial banks to reduce their own interest rates. Lower interest rates in the economy will:

Reduce the incentive to save. Lower interest rates give a smaller return from saving. This lower incentive to save will encourage consumers to spend rather than hold onto money.

Cheaper Borrowing costs. Lower interest rates make the cost of borrowing cheaper. It will encourage consumers and firms to take out loans to finance greater spending and investment.

Lower mortgage interest payments. A fall in interest rates will reduce the monthly cost of mortgage repayments. This will leave householders with more disposable income and should cause a rise in consumer spending.

Rising Asset Prices. Lower interest rates make it more attractive to buy assets such as housing. This will cause rise in house prices and therefore rise in wealth. Increased wealth will also encourage consumer spending as confidence will be higher. (wealth effect)

Depreciation in the Exchange Rate. A lower interest rate makes it relatively less attractive to save money in that country. Therefore there will be less demand for the currency causing a

fall in its value. A fall in the exchange rate makes exports more competitive and imports more expensive. This leads to an increase in AD. Evaluation

It affects people in different ways. The effect of higher interest rates does not affect each consumer equally. Those consumers with large mortgages will be disproportionately affected by rising interest rates. For example, reducing inflation may require interest rates to rise to a level that cause real hardship to those with large mortgages. This makes monetary policy less effective as a macroeconomic tool.

Time lags. The effect of rising interest rates can often take up to 18 months to have an effect. For example if you have an investment project 50% completed, you are likely to finish it off. However, the higher interest rates may discourage starting a new project in the next year.

It depends upon other variables in the economy. At times, a rise in interest rates may have less impact on reducing the growth of consumer spending. For example, if house prices continue to rise very quickly, people may feel that there is a real incentive to keep spending despite the rise in interest rates.

Real Interest Rate. It is worth bearing in mind that what is important is the real interest rate. The real interest rate is nominal interest rates minus inflation. Thus if interest rates rose from 5% to 6% but inflation rose from 2% to 5.5 %. This actually represents a cut in real interest rates from 3% (5-2) to 0.5% (6-5.5) Thus in this circumstance the rise in nominal interest rates actually represents expansionary monetary policy.

o o o http://www.economicshelp.org/blog/3417/interest-rates/effect-of-lower-interest-rates/ http://www.investopedia.com/ask/answers/03/112003.asp http://en.wikipedia.org/wiki/Interest_rate#Zero_interest_rate_policy

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o http://www.economist.com/blogs/buttonwood/2013/02/investing