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The Level of Interest Rates

What Determines the Overall Level of Interest Rates — That is, Why are Rates Higher at Some Times Than at Others?

Interest is the price of a loan, so it is determined to a large extent by the supply of, and demand for, credit, or loanable funds. Many different parties contribute to the supply and demand for credit.

  • When you put money into a bank account, you are allowing the bank to lend the funds to someone else. So, through the bank, you are contributing to the supply of credit in the economy.

  • When you buy a U.S. Savings Bond, you are lending funds
    to the U.S. government. Again, you are contributing to the supply of credit.

  • On the other hand, when you borrow — to buy a car, for example, or by keeping a balance on a credit card account
    — you are contributing to the demand for credit.

  • Individual savers and borrowers aren’t the only ones contributing to the supply of, and the demand for, credit. Business firms and governments in this country, and foreign organizations, too, affect the demand for, and supply of, credit.

Together, the actions of all of these participants in the credit market determine how high or low interest rates will be

All other things held constant, an increase in the demand for credit raises the price of credit, or interest rates, and a decrease in the demand for credit lowers interest rates.

All other things held constant, an increase in the supply of credit lowers interest rates, and a decrease in the supply of credit raises interest rates.

How Does Inflation Affect the Level of Interest Rates?

Inflation is one reason interest exists; lenders must be compensated for the decline in the purchasing power of what they lend. So, rates generally are high when inflation is expected to be rapid.

Inflation expectations are based heavily on recent inflation. So, rates generally are high when inflation is rapid.

 


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