Interest rates have an incredibly strong impact on our everyday life, though not everyone knows about it. In this article, we explain their fundamental role in the economy.
A scary and bureaucratic term that is in everyone’s ears but few people actually know its meaning. Many think, or hope, that it’s simply a far away reality that only professional economists should know. However, you will find that interest rates have everything to do with your daily finances, and therefore your daily life.
But what are interest rates? What do they impact and how? And, most importantly, how does it come back down to us, the common people that simply try to go on with our existences.
We will find out in this brief guide on interest rates.
What are interest rates
First and foremost, a bit of basic macroeconomy. Interest rates are, briefly, the “cost” of money. Have you ever asked for a loan to a bank? A mortgage for a new house perhaps? Well, then you will know that the bank will, yes, lend you money, but then will ask them back with some interest.
And the rate of that interest is exactly what we are talking about. A nation’s central bank decides the interest rates that every other bank will have to charge clients for. Whenever someone “borrows” money from that institute, they will have to give it back at a high or low interest rate, depending on what the central bank decides.
What do interest rates impact
Why would a central bank raise interest rates? Why would they raise the cost of the same money they are printing out for everybody? The answer is, as always, complicated.
There are times in a developed economy when there should be more (or less) money in circulation. This is necessary to keep the value of that money stable.
Imagine this: there is a sudden virus that kills off 99% of banana plantations. Luckily, I am the happy owner of one of the few remaining bananas in the world. I would, of course, sell it at very, very high prices. The value of bananas has skyrocketed because there is now a limited amount of it.
Now think of money in the same way. If there’s too much currency in circulation, money will be worth less and vice-versa. Hence, the job of central banks is precisely to keep the amount of money circulating stable, in order to avoid volatility in its value.
How can interest rate change the amount of money in circulation
By raising or lowering the “cost” of money (or, by raising or lowering interest rates), central banks can control the amount of money going around.
It’s a simple prediction on human nature. If money costs “more”, so there are high interest rates, people would be less inclined to spend it and rather keep it for themselves. Why would I sell the only banana remaining in the world to the first offer?
If, on the other hand, money costs “less”, so there are low interest rates, much more currency circulates in the market. There are more investments, more sales and the economy simply runs better. Until, that is, the money circulating is so much that it becomes virtually worthless.
And that is when inflation occurs.
Interest rates and inflation
An inattentive central bank would simply keep money circulation free and limitless. After all, so many people are spending, why stop now? Because, as we said before, when there is too much currency in circulation its value decreases rapidly. This phenomenon is known as “inflation”.
Indeed, there is a “healthy” level of inflation many central banks strive for (again, because money circulating is good for the economy). However, when it gets too high, central banks must pull the brakes.
Therefore, it is their duty to raise interest rates, making money more expensive, whenever inflation gets too high.
In short, raising interest rates allows inflation to go down.
How do interest rate impact my daily life
As we all know by now, interest rates have a massive impact on our daily lives. When interest rates are high, people will need to pay back a higher amount of money whenever taking a loan from a bank.
Not only that but, with less money circulating, the overall economy simply struggles to grow. With high interest rates there is always the very real possibility of incurring a recession, because investors and banks prefer to hang to their money rather than spend it.
In these months, central banks have raised interest rates to fight the massive post-Covid inflation. And indeed, many are also worried that we could fall into a recession by the end of 2023.
But inflation could have far worse effects than a recession, therefore central banks must hang tight and keep interest rates high.
And, as we tried to explain into this article, the results for everyone could be catastrophic.
