I just got a basic question from one of our readers by em-mail. Since this question has repeated a few times, here is a quick post on ‘How Interest Rates Work and affect economy‘.

Just modified the question a bit. Usually the question is ‘how does interest rates affect individuals, how interest rates affect stock returns, Should we monitor interest rates etc.,’.

Some of you might feel this basic finance but for many it will be useful in understanding interest rates & its effects.

As you all know, interest is the charge applied on borrowed money. In any free economy, interest rates are the cost of doing business in that lenders expect to be remunerated for their services and departing with their capital.

Interest rates are a significant influence on any economy and the prosperity of the nation. Fluctuations in interest rates set the pace for investment markets, assets markets, and almost any other commodity connected to financial markets.

Understanding the effects of interest rate changes and their influence on the market helps you learn on how they impact your wallet and your investments.

How Interest Rates Affect Economy

There is usually a general nervousness surrounding speculations of interest rates going up. Most people, and rightly so, believe that such changes affect business, in a good or bad way.

So why do interest rates go up or down? Well, in most countries, the central bank is charged with the duty of determining interest rates.

Hence, the Reserve Bank of India decides on when interest rates should go up or down. The RBI is the sole determiner of India’s monetary policy and has the power to determine two short-term interest rates outlined below.

Check recent RBI interest rates here

The Bank Rate (Repo rate)

The Repo rate refers to the rate the Reserve Bank of India (RBI) charges on money it lends to other banks.

So it can decide to lend money at a higher rate, or a lower rate. By lowering its lending rates, the Reserve Bank increases the liquidity and money supply in the market.

So when Reserve Bank reduces interest rate, the commercial Banks like ICICI, SBI which borrow from RBI can do so at reduced rates.

People/Businesses will borrow money and invest capital into new business ventures benefiting the country. Upping or increasing the Repo rates has the reverse effect.

The Cash reserve Ratio (CRR)

The RBI also sets the limits of cash to be deposited by commercial banks with RBI. This rate is called the Cash reserve Ratio(CRR) .Should the RBI set high CRR, commercial banks will tighten up in advancing loans to the public, resulting in a less liquid market.

If the RBI sets a low ceiling, then commercial banks will be more willing to extend loans, thereby increasing money circulation in the market.

At any point in time, CRR is usually around but not less than 4% of NTDL (Net Demand and Time Liabilities) every 14 day cycle.

With these two tools, the RBI can decide when interest rates should go up, and when they should go down and by how much.

The general belief is lower interest rates are a good thing. But there are circumstances when a higher interest rate is necessary.

A good example is trying to control the fluctuation of the Indian Rupee against foreign currencies and high inflation. Too much rupee may result in the decline of its value, and hence the price of things will go up.

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Why the RBI Fluctuates Interest Rates to Increase or Slow Down Economic Growth

When the RBI changes interest rates, a chain reaction occurs. The intended chain reaction is one that either spurs the economy’s growth or slows down the economy.

In essence, as a policy maker, and gatekeeper of the Indian economy, the RBI is in charge of maintaining the health of the economy. For instance, when the economic growth of the country is low, the RBI lowers the interest rates.

You must remember that in last one year RBI has reduced interest rates by more than 100bps to improve economic activity.

Doing so results in lower charges on consumer/business and home loans. Hence, people are encouraged to borrow. The net effect is increased market liquidity and increased investment.

Hence, the economy grows. Moreover, if the economy is growing too fast, or heating up, the RBI may decide to increase the interest rates, thereby cooling things off.

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Interest Rate and Merry-Go Round Analogy

I read this below example somewhere long ago and it very simply explains the concept of interest rate.

An analogy of the above paragraph is a merry-go-round. When a merry-go-round is going at the right speed – not too slow or too fast – it is enjoyable.

Let’s say a merry-go-round represents the Indian economy and the RBI is the person at the controls of the merry-go-round. If the merry-go-round slows down, it is the job of the person in charge to pull a few levers helping the merry-go-round picks up speed.

If it is going too fast, then the person has to pull a few levers to make it slow down. The levers in this example represent the interest rates.

Riding a merry-go-round that’s moving too slow is a dull experience. We want some speed to make things exciting. The same applies to a slow-growing economy.

We want an economy that is steadily growing, giving us access to the best and latest products, at the best prices. On the other hand, a fast-moving merry-go-round would make us woozy, or it might heat up and break down.

We want a merry-go-round moving at the right speed. The RBI makes sure our economic merry-go-round moves at the right speed, which is neither too dull for us nor too fast. The RBI ensures the majority of people have a pleasant ride in merry-go-round terms.

However, not everyone will be happy. Some want it to slow down while others want it to pick up more speed. But the RBI does what is best for the overall economy.

How Interest Rates affect Individuals

As the RBI raises or lowers short-term interest rates, banks raise or lower interest charged on loans. These changes affect both the individual and the entire economy.

For the individual, bank lending rates affect the interest charged on home/consumer loans, mortgages, and credit cards. Let’s say for instance you have a floating interest home loan (Remember banks always lend at floating rates unless you specifically ask for fixed rate).

The EMI payments you pay at the end of the month are dependent on the interest rates.

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So if you pay 20,000 INR this month where interest=Rs 8000 and Principal=Rs 12000 and the next month the RBI/banks increases the interest rates, you might end up paying same 20, 000 INR your interest would have increased to Rs 8200 and principal=Rs11800. This way you’ll take long to pay your home loan.

If you are lucky and the RBI lowers the interest rates, then you pay less on your mortgage. The effect is not only limited to mortgages, but it applies to other things such as the price of assets, return on investments, and just about anything with a monetary value attached to it.

The effects of interest rate fluctuations on the entire economy occur in several other ways as well. A hike in lending rates may result in few customers taking out car loans from banks. The result of this is a dismal performance of the automobile industry, gasoline industry, and anything connected to the motor industry.

Think of it as a domino effect. When one domino falls (consumers are not taking out car loans), then any other domino connected to it follows.

The converse is true. Low-interest rates attract consumers to take out loans. To make things interesting, let’s use education loans as an example this time round.

A lower interest rate allows consumers to take out loans to pursue education and purchases automobiles, homes. The result is a more literate population , better employment, better purchasing power and good industry and business growth in economy.

In a nutshell, an increase in interest rates results in slow economic growth since consumers have fewer rupees to spend, and even lesser motivation to borrow.

But a lowering of interest rates may lead to economic growth since consumers have more to spend and are more willing to lend.

Hope this was useful in providing a basic idea of how interest rates work and affect economy. Let me know if you think I’m right.