Summary

Generally speaking, no one is willing to lend money for free. If Alice borrows $10,000 from Bob, Bob usually needs to pay Bob a certain amount of additional financial incentives to facilitate the loan transaction. This incentive is interest - a charge on top of the principal borrowed by Alice.

The increase or decrease in interest rates will significantly affect the public’s borrowing behavior, and ultimately affect the overall trend of the economy. From a macro perspective:

• Rising interest rates will encourage people to deposit money, because at this time, deposits can get higher interest from banks. The appeal of the loan becomes less attractive because you pay higher interest on the money you borrow.
• Falling interest rates will encourage borrowing and consumption, because the spare money in hand will not generate much income at this time, and loans do not need to pay high interest.

Introduction

As in "How Does the Economy Work?" "As mentioned in the article, credit plays a vital role in global economic development. Essentially, it is the lubricant of financial transactions, allowing individuals to obtain loans without having funds and repay them as agreed. Enterprises can use credit loans to purchase production resources and repay the loan to the lender after using the production resources to make a profit. Consumers can use the loan to purchase goods and then repay the loan in small increments on demand.

Of course, in order for lenders to be willing to provide loans, there first needs to be a financial incentive. Usually, they charge a certain amount of interest. In this article, we’ll take a closer look at interest rates and how they work.

What is interest rate?

Interest is usually an additional payment that a borrower needs to make to a lender. If Alice asks Bob to borrow money, Bob might say that he can lend $10,000 but at 5% interest. This means that Alice needs to repay Bob the original $10,000 (principal) plus 5% interest when repaying the loan. Her final repayments to Bob totaled $10,500.

The interest rate is therefore the percentage of interest owed each period. If the annual interest rate is 5%, Alice will need to repay $10,500 in the first year. The specific calculation results are as follows:

• Simple interest– The future annual interest is 5% of the principal

or 

• Compound interest – 5% of $10,500 in the first year, 5% of $10,500 + $525 = $11,025 in the second year, and so on.

Why are interest rates important?

Unless trading purely with cryptocurrencies, cash or gold coins, interest rates will definitely have an impact on us. Even if you have been paying in Dogecoin, you will still feel the impact of interest rates. The importance of interest rates in the entire economic system is self-evident.

Take commercial banks as an example: their overall business model (fractional reserve system) revolves around the lending of funds. Savers deposit funds and are equivalent to lenders. Banks lend their funds to others and pay depositors a certain amount of interest. Instead, the borrower pays interest to the bank.

Commercial banks are subject to many restrictions when setting interest rates, and the dominant power is held by the "central bank". The Federal Reserve, the People's Bank of China or the Bank of England are all central banks. Their responsibility is to correct the economic trajectory and safeguard the healthy development of the economy. As a result, central banks often raise or lower interest rates.

Assuming the interest rate is high, you can earn more interest on your deposit. And high-value loans require high interest payments. Conversely, if interest rates are lower, the return on deposits falls and borrowing becomes more attractive.

Ultimately, these measures control consumer behavior. The purpose of lowering interest rates is usually to stimulate consumption when consumption is slowing because it encourages individuals and businesses to borrow. After getting more loans, they will naturally spend in the market.

Cutting interest rates may have a better effect on revitalizing the economy in the short term, but it will trigger inflation. There is more credit available, but the amount of resources remains the same. In other words, the demand for a good increases and the supply remains the same. Then the price will naturally start to rise until it reaches equilibrium.

At this time, raising interest rates can be used as a solution. At this point everyone will start paying back their loans, reducing the total amount of credit in circulation. At this stage, people usually deposit their funds in banks to earn interest because banks offer generous deposit interest rates. Economic growth is likely to slow again as demand for goods dwindles and inflation falls.

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What is negative interest rate?

Economists and pundits often talk about negative interest rates. As you can imagine, negative interest rates mean that the interest rate is below zero. If you want to lend money or deposit it in a bank, you still need to pay interest. As a result, the cost of bank lending will increase. The cost of saving will also increase.

This concept may sound like a fantasy. After all, after the lender lends the money, it still bears the risk that the borrower cannot repay the loan. Why should it pay interest instead?  

So, negative interest rates are the last resort to repair economic difficulties. The concept was born out of concerns that people might prefer to hold on to their money during an economic downturn and wait until the economy recovers before participating in various economic activities.

When the interest rate is negative, the above behavior makes no sense. Borrowing and consumption seem to be the wisest choices. So in extreme economic conditions, some would argue that negative interest rates are an effective solution.

Summary

On the surface, interest rates appear to be a relatively simple concept.

But they are an integral part of the modern economy, and as we have seen, adjusting interest rates can fundamentally change the behavior of individuals and businesses. Therefore, the central bank usually uses interest rates as a means to actively regulate the market and maintain the normal operation of the national economy.

Got any more questions about interest rates and the economy? Please visit our Q&A platform Ask Academy, where members of the Binance community will patiently answer your questions.