Interest Rate – Definition & Key Factors That Influence Interest Rate

In a free economy, funds are allocated through the price system. The interest rate is the price paid to borrow funds whereas in the case of equity capital, investors expect to receive dividends and capital gains.

The factors that affect the supply and demand for investment capital, hence the cost of money, are production opportunities, time preferences for consumption, risk, and expected inflation.

The rate of interest paid to savers depend on:

• The rate of return producers on invested capital
• Savers’ time preferences for current versus future consumption
• The riskiness of the loan
• The expected future rate of inflation.

For each type of capital, such as home loans, farm loans, business loans, there is a price. These prices change over time, and shifts in demand and supply occur.

Short-term interest rates are very responsive to current economic conditions whereas long–term rates primarily reflect long-run expectations for inflation.

Long –term rates have been volatile because investors are not sure if inflation is truly under control. The level of interest rates  will vary with changes in the current rate of inflation and expectations about future inflation.

KEY FACTORS THAT INFLUENCE INTEREST RATE LEVELS

1. Federal Reserve Policy 

The money supply has a major effect on both the level of economic activity and the rate of inflation. If the government wants to control the growth in the economy, it slows down the money supply. The initial effect is to cause interest rates to rise and inflation to stabilize.

During periods when the central bank is actively intervening in the markets, the yield curve will be distorted. Short-term rates will be temporarily too low if central bank is easing credit and too high if it is tightening credit.

Long-term rates are not affected as much by FED intervention because they represent  the averages of short-term expectations.

2. Federal Budget Deficit

If government spending is greater than its revenues, it runs a deficit . Deficit must be covered either by borrowing or printing money.

If the government borrows, this added demand for funds pushes up the interest rate. If it prints money, this increases expectations for future inflation which also drives up interest rates.

Thus, the larger the government deficit, other things held constant, the higher the level of interest rates. Whether long or short term rates are most affected depends on how the deficit is financed. So, we can’t state in general how deficits will affect the slope of the yield curve.

3. The Foreign Trade Balance

If a country imports  more than it exports, it runs a foreign trade deficit. This deficit is usually financed with debt. The higher the deficit, the more it must borrow and this drives the interest rates up.

If FED decreases the interest rates in the U.S. below those in other countries, foreigners will sell U.S. bonds which will depress bond prices and cause U.S. interest rates to increase. Thus, the existence of a deficit trade balance hinders the FED’s ability to combat a recession by lowering interest rates.

4. The Level of Business Activity

During recessions, short-term rates decline more sharply than long-term rates. This occurs because the FED operates mainly in the short-term sector, so the intervention has the strongest effect here. Long-term rates reflect the average expected inflation rate over the next 20-30 years and this expectation does not change much, even when the current level of inflation is low or high.

What are The Effects of Interest Rates on The Stock Market?

Interest rates have two effects on corporate profits:

1. The higher the rate of interest, the lower a firm’s profits, other things held constant.
2. Interest rates affect the level of economic activity which in turn affects corporate profits.

If interest rates rise sharply, investors can get higher returns in the bond market, which induces them to sell stocks and to transfer funds from the stock market to the bond market. This may depress stock prices.

The reverse happens if interest rates decline. So, interest rate changes affect business decisions regarding financing of investments.