Understanding what interest rates are is essential for everyday life. In this article, we’ll analyze how this crucial financial instrument works.
Interest rates represent the cost of “borrowing money”, defining the extra amount the borrower has to pay to the lender after the transaction takes place.
Understanding what interest rates are is crucial to having a basic financial education. In today’s world, money is all that matters, and knowing its “cost” is imperative for a successful and thriving life. Furthermore, interest rates have been at the center of the political debate for the past years, having an immense impact on the daily lives of millions of people.
So let’s see exactly what interest rates are.
Interest rates: what are they?
The basic definition and explanation of interest rates are that they represent the “cost of money”. Interest rates are measured as a percentage of the borrowed amount of money over a certain period.
Essentially, they represent how much it costs to borrow money and how much bank savings yield.
A typical textbook example is the interest rate of a financing transaction: whether it is a mortgage to a family or a small saver or whether it is a loan granted to a company, by interest rate we mean the cost of borrowed money.
This cost is calculated as percentage on the total amount loaned by lenders, which are mainly banks.
Any financing operation has a cost and this corresponds to the interest rate. It is therefore evident that those who obtain the loan pay the interest rate to their creditor (the bank) and that, specularly for those who receive it, they represent a revenue (for banks, interest rates are items of monetary income).
Interest rates: how do they work?
The purchase of money (taking out a loan) or the sale of money (offering a loan) determines a market where every day a demand and an offer of money are formed and created: on the supply side some disburse money (the banks), on the demand side some borrow it (savers).
According to the classical laws of economics, the price of money is formed from the encounter between supply and demand, but that’s not all. In circulation, in addition to the money deriving from loans/financing, there is also the currency deriving from the exchange of goods and services.
Monetary transfers occur every day that change the amount of money in circulation.
Again according to the laws of economics, the greater the availability of a good in circulation, the lower its price will be, and vice versa, the smaller the quantity of money in circulation, the higher its price.
Interest rates: the role of central banks
This is true for every country and every economy in the world but it is clear that this process of forming the price of money and the quantity of money in circulation is not accidental.
But who regulates the money market then?
Banks, of course. But even before that, the central banks, hierarchically above the institutions where the saver goes to obtain a loan: in the case of Europe it is the ECB.
The European Central Bank is the authority that manages the monetary policy of the Eurozone countries. Its main objective is to keep the inflation rate stable at a target level of 2%/year.
ECB interest rates
But how does the ECB do this? Through interest rates.
According to the reasoning described above, two scenarios can occur:
- rate increases, the cost of money will be higher and the supply of money in circulation will decrease (restrictive monetary policy);
- decrease in rates, the cost of money will be lower and the money supply will increase (expansionary policy).
There are three types of interest rates that the ECB uses to express monetary policy decisions and which then have a direct impact on the rates that banks apply on loans and mortgages to savers:
- interest rates on main refinancing operations, ie the interest paid by banks when they borrow from the ECB for one week;
- interest rates on marginal lending facility operations, ie the interest paid by banks when they borrow from the ECB overnight;
- interest rates on deposits at the central bank are those that banks receive, or must pay in the event of negative interest rates, on their overnight deposits with the ECB.
