Question

What are the main determinants of the interest rates? Which factors are more important than the others? Why?

Answer 1

The main determinants of Interest Rates are as follow (assuming we are discussing determinants in Macro Economics and not micro economics - firm level) :-

1) Economy and demand and supply for money cycle:

The general economic conditions are among the prime factors that influence the movement of interest rates. In a upward moving or growing/developing economy, people are able to secure earnings which in turns gives them the ability to borrow and purchase commodities and services. The buy house, car, consumer appliances, electronics et al which in turn increases demand for more money, which in turn affects the general rate of interest in an upward direction. It is opposite in a recessionary economic condition.

2) Inflation:

The rate of inflation typically consumer price inflation as it affects the consumers directly. Anyone into investing would know that in order to make money's worth more over the period of time has to beat Inflation as the single more important factor apart from safety of capital. The lenders of money would prefer to lend at a higher rate which atleast cover the cost in terms of inflation rate. Thus a increase in inflation rate for an economy gives way for increase in interest rate.

3) Central banker:

The central bank of a country has a tool which is called the monetary policy under which is has direct control of cost of funds or the general rate of interest in the economy. The bank considers several factors that before it decides the rate of interest. Generally this rate of interest is transferred through public and private banks as these banks end of borrowing from central bank and also this rates gives them a base rate for defining their own rate of lending to their customers.

4) Fiscal deficit:

The Government of any country borrows and spends money and most of the developing economies in the world are in a deficit of funds to spend in the economy. When this situation happens the government increase the rate of interest it offers on its borrowings and savings schemes.

The single most important factor that any country would consider before setting the interest rate is Inflation, because inflation defines at what rate the money would depreciate over the period i.e. the worth of money say after one year of inflation. Investors and lenders need to consider Inflation so that they are able to cover one of the important cost.