Ethiopian Reporter - English Version - Interest rates and inflation

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Interest rates and inflation

Saturday, 05 April 2008

An interest rate is the cost of borrowing money. A borrower pays interest for the ability to spend money now, rather than wait until he's saved the same amount. Interest rates are expressed as an annual percentage of the total amount borrowed, also known as the principle.

Interest rates aren't just random punishments for borrowing money. The interest a lender receives is his compensation for taking a risk. With every loan, there's a risk that the borrower won't be able to pay it back. The higher the risk that the borrower will default (fail to repay the loan) is, the higher the interest rate. That's why maintaining a good credit score will help lower the interest rates offered to you by lenders.

The nice thing is that interest rates work both ways. Banks, governments and other large financial institutions need cash, too, and they're willing to pay for it. If you put money into a savings account at a bank, the bank will pay you interest for the temporary use of that money. Governments sell bonds and other securities for the same reason. In this case, you're the lender, and the interest rate is your compensation for temporarily giving up the ability to spend your cash. Unfortunately, savings accounts and government-issued bonds pay relatively low interest rates because the risk of defaulting is close to zero.

Long-term loans also carry higher interest rates than short-term loans, because the more time a borrower has to pay back a loan, the more time there is for things to go rotten financially, causing the borrower to default.

Another factor that makes long-term loans less attractive to lenders -- and therefore raises long-term interest rates -- is inflation. In a healthy economy, inflation almost always rises, meaning the same dollar amount today is worth less five years from now. Lenders know that the longer it takes the borrower to pay back a loan, the less that money is going to be worth.

That's why interest rates are actually calculated as two different values: the nominal rate and the real rate. The nominal rate is the interest rate set by the lending institution. The real rate is the nominal rate minus the rate of inflation.

The economy is a living, breathing, deeply interconnected system. When the interest rates at which banks borrow money are changed, those changes get passed on to the rest of the economy.

Inflation is the rise over time in the prices of goods and services. It's usually measured as an annual percentage, just like interest rates. Most people automatically think of inflation as a bad thing, but that's not necessarily the case. Inflation is the natural byproduct of a robust, growing economy. No inflation, or deflation (the lowering of prices), is actually a much worse economic indicator. Also, in a healthy economy, wages rise at the same rate as prices.

A standard explanation for the cause of inflation is "too much money chasing too few goods".

   1. For several possible reasons, more money is being spent than normal. This could be because interest rates are low and people are borrowing more. Or perhaps the government is spending a lot on defense contracts during a war.
   2. There's not enough supply to keep up with the rising demand. Manufacturers are producing goods at a slower rate than people are demanding goods.
   3. When supply is less than demand, prices go up.

So how do interest rates affect the rise and fall of inflation? Lower interest rates put more borrowing power in the hands of consumers. And when consumers spend more, the economy grows, naturally creating inflation. If government decides that the economy is growing too fast-that demand will greatly outpace supply-then it can raise interest rates, slowing the amount of cash entering the economy.

(contributed by Dawit Alema)

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