Question

What is an interest rate? Explain how interest rates may be unrelated to money or financial assets? How are interest rates are determined? Why do we observe a number of interest rates in the economy rather than a single interest rate? What are some of the reasons interest rates vary?

Answer 1

The interest rate is the amount that is charged as % of the principal amount of a loan by the lender for using his money by the borrower. In simpler terms, it can be said that a interest rate is the charge that a borrower pays for using the money of lender. The rate of interest charged is usually not determined by the amount of financial asset or the money that is being lent, it is rather influenced by the capacity of the individual to pay back the same. If one can afford to pay up to $1M, lending him $8,00,000 would not make the rate of interest rate lower for him, it is going to be the same. Therefore, it can be said that interest rate is unrelated to financial assets or money in general.The rate of interest that a lender will charge from the borrower will depend on various factors which includes the borrowing capacity of the borrower, credit rating of the borrower, prevailing interest rate in the market, the time period for which the money is being lent and other risks associated with the lending. There exist number of interest rate in a economy because of different capacity of lenders and borrowers, a bank with enough cash to park may charge a lower interest rate for the same amount for which another bank was charging higher interest rate. Therefore, it is all based on demand and supply of funds in the market of lending. If there is high supply of funds with not much borrowing, then interest will automatically be lower to attract borrowers, while if in a state there is a shortage of funds and demand is high then it will lead to higher rate of interest rate. Therefore, the concept of uniform interest can exist and as economy grows the rate of interest is ascertained by the market and its elements like demand and supply. Some of the reasons why interest vary include borrowing capacity the individual who borrows, it can be a country as well, demand and supply of funds, situation of the economy ( a healthy economy is depicted by low rate of interest),