Explain the determinants of interest rate.
Interest rate is the price paid by the borrower to the lender for the use of lender’s fund. The same interest payment is income for the lender and cost for the borrower. The interest rate is determined by the various factors. Some of the important factors which helps to determine the interest are briefly described below:
1.Demand and supply of fund:
The demand and supply of fund is the main determinants of the interest rate. The equilibrium interest rate is determined where demand and supply of fund intersect each other. Higher the demand for fund over supply, higher will be the interest rate. And higher the supply of fund over demand lower will be the interest rate. It can be shown by following figure:
2.Inflationary Expectation
Inflation is also a determinants of the interest rate. Inflation refers to the rate at which prices for goods and services rises. Higher the expected inflation in an economy higher will be the interest rate and vice-versa.
3.Monetary policy:
The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is concerned with money flow and money contraction in the economy. Under expansionary monetary policy, the central bank supply more money in an economy which leads to decrease in interest rate and under contracsionary monetary policy, the central bank stop money supply in an economy which leads to increase in interest rate.
4.The phase of business cycle:
The phase of business cycle in the country affects the credit condition by affecting supply of and demand for loanable fund. For example, during the period of rapid economic growth, the business activities prosper, unemployment falls and as a result the demand for loanable fund increases to finance the economic growth which raises the level of interest rate and vice-versa.
5.Size of government deficit:
When the government spending is higher than its revenue, it results into government budget deficit. A continuous government budget deficit leads to massive borrowing by government to finance the deficit budget. As a result there will be the borrowing competition between the government and businesses and the level of interest rate will be increase due to excess demand over supply.