Question

Explain the factors that determines interest rates?

Answer 1

Below are the factors that determine the interest rates:

1. Demand-supply of funds: The demand and supply of funds determine the interest rates in the market. The suppliers are the economic agents with surplus funds (savers) whereas the demanders are economic agents are economic agents with deficit funds. Financial markets allows them to meet and negotiate the interest rates. In the periods of excess demand the interest rates may hit the roof. The reverse may also hold true.

2. Inflation: The savers are concerned with real rate of return on their investments. In the event of high inflation, they will charge a higher interest rate to compensate for the inflation.

3. Central bank: Central banks play a key role in influencing the interest rates. For e.g. They often use open market operations to affect the Federal fund rates which directly affect the interest rate in the economy.

4. Other factors: These include the risks in the economic system such as default risk and liquidity risk. Investors may ask borrowers to compensate them for these risks.