Question

The interest rate is the price of loanable funds in financial markets, and the equilibrium interest rate is the price that equates the demand for and supply of loanable funds. Interest rates may move from an existing equilibrium level to a new equilibrium level as the result change in the supply of or demand for loanable funds. For example, if the quantity of loanable funds being demanded increases due to new business opportunities, suppliers of loanable funds will need to be offered a higher interest rate so that the supply of and demand for loanable funds will be brought back into balance. What is the “interest rate,” and how is it determined?

Answer 1

Interest rate in simple terms is the amount the lender charges on the borrower which is calculated based on the principal usually a percentage on the principal. The borrower pays interest to the lender on a periodic basis mostly annual, semi-annual, quarterly basis.

Eg. Bank lends various types of loans to people inturn receives interest from them on a periodic basis. Similarly governments and corporates issue bonds wherin the bond holder receives interest from them in the form of coupons periodically.

Typically interest rates are determined by the Central Bank of that particular country say Federal Reserve in case of U. S based on their respective monetary policies. They regularly keep an eye on interest rates so that money supply in the economy is maintained at an optimum level. Interest rates are therefore also based on supply and demand. Whenever there is an increase in demand for money,there is an increase in interest rates and vice versa.Inflation also has a key role in determining the interest rates.

Say the price/value of goods/services increase by the time the borrower has repaid the loan amount. But the purchasing power of that money would have decreased by then.

There is another risk which is associated with the process of lending which is credit risk or default risk. If we are lending money to some one there are chances that he/she would default on that. He we are acrually taking a risk by lending to that person.This is the same in case of Bonds also. Companies issuing bond with lower risk(Typically AAA Bonds ) pays lower interest rates as the credit risk is very less while companies issuing risky bonds/junk bonds they tend to pay higher interst rates.

All these factors affect the interest rates.