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Importance of Investments

Interest Rates

Earlier in this module, we encountered the word "Interest" several times. So, in this unit, let us elaborate on the concept of interest and interest rates. 


What is Interest and Interest Rates? What are the factors that govern interest rates in an economy?



Interest is the amount charged to the borrower for the privilege of using the lender's money. It is calculated as a percentage of the principal balance (the amount borrowed). There are two methods to calculate interest- simple interest and compound interest. We will learn both of them in the upcoming units of this module.


Interest Rates

It is the rate at which the borrower pays interest on a loan. Interest rates have a bearing on all fixed income securities and other Government instruments as well because the price of all these securities have an inverse relation with interest rates.


The factors which govern these interest rates are mostly related to the overall economic structure and are referred to as macroeconomic factors which can be summarized as:

  • Budgetary Deficit: Budget deficit occurs when the spending of the government exceeds its income over a given period.
  • Supply & Demand of Money: The supply and demand of money influences the monetary decisions by the RBI. When the RBI feels that liquidity is plenty in the economy and spending should be curtailed to avoid overheating of the economy, it decreases the supply of money and when it feels that economic growth is slowing down and liquidity is scarce, it increases the supply of money.
  • Inflation rate: Inflation is the persistent increase in the price levels of a particular commodity over a period of time. The key word here is persistent because inflation occurs only when prices keep increasing on a constant basis. 

Inflation can be of two types, cost push and demand-pull inflation wherein cost push means when there is a gradual increase in cost of raw materials which in turn leads to an increase in the prices of the goods while demand pull inflation is a case where the demand increases at a rate faster than the supply which leads to an increase in the prices.


Let us also consider two other probable scenarios:


To cool down high inflation: the interest rate is increased.

When the interest rate rises, the cost of borrowing rises. This makes borrowing expensive. Hence borrowing will decline and as such the money supply (i.e. the amount of money in circulation) will fall. A fall in the money supply will lead to people having less money to spend on goods and services. Hence, they will buy a lesser amount of goods and services. This, in turn, will lead to a fall in the demand for goods and services. With the supply remaining constant and the demand for goods and services declining; the price of goods and services will fall. As inflation is a continuous increase in the general price level of goods and services so a fall in the general price level of goods and services will lead to a decline in inflation levels.


In low inflationary situations, the interest rate is reduced

A fall in interest rates will make borrowing cheaper. Hence, borrowing will increase and the money supply will also increase. With a rise in money supply, people will have more money to spend on goods and services. So, the demand for goods and services will increase and with supply remaining constant this leads to a rise in the price level i.e. inflation.


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Units 13/16