scorecardresearchWhy do interest rates fluctuate? An explainer

Why do interest rates fluctuate? An explainer

Updated: 18 Sep 2022, 11:00 AM IST
TL;DR.

Understanding how current interest rates fluctuate is crucial since they have a big impact on how much money you can earn. We discuss all the major reasons in detail.

Understanding how current interest rates fluctuate is crucial since they have a big impact on how much money you can earn. 

Understanding how current interest rates fluctuate is crucial since they have a big impact on how much money you can earn. 

Lending money comes with a fee called an interest rate. Alternately, it might be the payment for the risk and service involved in lending money. In both situations, it stimulates borrowing, lending, and spending, which keeps the economy running. However, market interest rates are always fluctuating, and different loan kinds provide various interest rates.

Now, there are various reasons why the interest rate keeps fluctuating in an economy. Let us discuss one by one.

Monetary policies

The monetary policy is managed by the RBI. Through its primary policy rates, the repo rate and reverse repo rate, as well as ratios, the cash reserve ratio and statutory liquidity ratio, it regulates monetary activities such as the money supply, liquidity, and interest rates .

The interest rates are measured against the key policy rates set by the RBI. Similar to this, the policy ratios serve as checks and balances on the system's liquidity. The RBI periodically adjusts these factors based on the state of the economy.

Demand and supply

The rate of interest will rise as the demand for loans and credit rises, but it will decline as the supply of credit increases. When customers create bank accounts, the amount of credit increases and more money is available for lending. However, when borrowers put off making payments on their loans, less credit becomes available, which raises the interest rate.

The increased demand for capital has an increasing impact on interest rates. Interest rates often decrease during economic slowdowns or recessions because the reverse tends to occur.

Inflation

Inflation, the overall price rise experienced by the economy, is taken into consideration while determining the prices of all products and commodities. Interest rates, which represent the cost of money, follow this general norm. In an environment of rising inflation, savers must be paid through higher interest rates for forgoing their present consumption goals.

If they get a positive real rate of return, investors will sacrifice their present spending and invest in fixed income securities. The goal is to maintain a positive real rate of return so that the saver continues to save after inflation. Thus, interest rates tend to increase during periods of high inflation and vice versa.

Foreign investments and borrowings

The economic circumstances of foreign markets have begun to have a significant influence in determining the direction of interest rates as a result of the recent increase in globalization. Global economic conditions have an impact on how international investors lend to local businesses, which puts domestic sources of funding in direct competition.

If interest rates are rising internationally, India's interest rates must rise if it wants to draw in foreign investment. Attractive interest rates attract investment and help to stabilize the foreign currency rate.

Government borrowings

When government spending overruns government receipts, it results in a fiscal deficit. The government turns to borrowing to cover this deficit. The amount of borrowing by the government, which is the biggest borrower in the economy, affects the demand for money and, in turn, affects interest rates. Increased interest rates are correlated with higher government borrowing and fiscal deficits. Bond rates often rise as a result of increased fiscal deficits in the bond market.

Understanding how current interest rates fluctuate is crucial since they have a big impact on how much money you can earn through lending, how much bonds cost, and how much you'll spend to borrow money. Understanding how a debt security's qualities affect the type of interest rate you may get is crucial when selecting whether or not to invest in one.

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This is the relationship between economy and financial markets 
First Published: 18 Sep 2022, 11:00 AM IST