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INTEREST RATES
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INTEREST RATES PRELIMINARY ECONOMICS INTEREST RATES Interest rate is the cost involved when money is borrowed so that goods and services can be purchased now rather than in the future. Therefore interest is the cost involved for the use of that money. This cost is often referred to as the price which has to be paid for liquid capital. An Interest rate is comprised of three parts that are necessary to compensate the lender for lending money. There parts are compensation for • Risk- in lending money there is a risk involved that the lender may loose part or the entire original amount lent. • Inflation- in times of price inflation the principal loses purchasing power and the longer the period of loan and the higher the rate of inflation the greater the value that would be lost • Waiting- by waiting, the lender is forgoing present spending on goods or services or the ability to invest elsewhere. Since inflation affects everyone in the economy to some extent and the compensation for waiting can be assumed to be similar among lenders, the risk involved in lending funds is said to be the main factor is governing the different types of interest rates. Lending to governments is very low risk and this is reflected in bond rates being at the low end of the range of interest rates quoted in the financial markets. Similarly, lending to banks in the form of deposits is also low risk and hence only attracts low interest rates. Housing loans are considered more risky, so the interest rates are higher and lending to businesses is more risky still and hence attract even higher rates. TYPES OF INTEREST RATES Apart from bank loans a key interest rate in the economy is treasury bonds. Similarly Private, public and state-owned firms issue bonds as well. Both state and firm bonds can be exchanged in public markets. Households receive interest on their bank accounts. The interest is usually higher if they block money for a certain period of time in a savings account or lower if it is a current account. Conversely, households pay an interest when taking loans for consumption purposes. SHORT- TERM INTEREST RATES Short term interest rates are very sensitive to the economic performance. This is because the business cycle has a greater impact on short term than long term interest rates. During periods of strong growth, businesses and consumers will increase the demand for funds from the money market. This tends to increase the short term interest rates. When production declines, businesses will reduce the demands for funds, and therefore cause interest rates to decline. However the greatest influence on short-term interest rates is directly influences by the monetary policy’s activities.
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