Interest rates

The time value of money

In our last article, we mentioned that banks use depositors’ money to give out loans and collecting interest from these loans is the main way they profit. Interest is essentially paying someone to use money. 

But why should I have to pay people just to borrow money? 

Interest rates are usually determined via 2 main factors: 

Inflation: A seemingly obvious factor, but one that often people forget. If you lend $100 to someone, it will lose purchasing power due to inflation overtime. So even if the person pays back the $100 in a year’s time, it will be worth less than when it was first loaned. As such, an interest rate of say, 5% per year, will compensate for the lost value. 

Default risk premium: Loans are risky, more so for the lender than for you (the borrower). If you don’t pay back the loan (or “forget” to), the lender loses all that money. The chances of this happening obviously vary from loan-to-loan, but even very low-risk loans aren’t completely safe. Thus the risk of the lender not getting their money back also needs to be compensated. 

Depending on the loan, the lender may look at other components (i.e. liquidity premiums), but almost all loans have inflation and the default risk taken into account. The inflation factor differentiates between a real interest rate, which accounts for inflation, and a nominal interest rate which doesn’t account for inflation. 

Can interest rates ever turn negative? 

Think about what this means for a minute. If interest rates are payments that you give to the lender, then a negative interest rate is in the reverse - a lender “pays” you. It certainly is an unusual monetary tool that is used only during deep economic recessions to counter deflationary spirals. 

In recessions, aggregate demand decreases and companies produce less; lower demand means lower prices. This means cutting back production and laying off workers - unemployment. Most of these people will struggle to get work during a recession (given how companies are looking to decrease their workforce) and so they will eventually fail to pay various different loans such as mortgages. Expand these effects throughout the economy, and you’re looking at the country’s wealth slowly disappearing. 

Since the economy is declining, people are reluctant to spend money, which in turn causes further job losses and lower prices, creating a downward spiral. However with a negative interest rate, people are encouraged to take out loans and in hopes of driving up spending. 

The poverty risk with this is that it may end up backfiring -  interest rates are how banks profit, especially for assets like mortgages. So if these assets are then turned into liabilities (since banks have to now pay lenders, they’re losing money), the negative interest rates could cut profit margins to such an extent that banks are actually willing to lend less.

This is why policymakers will only set interest rates to negative in extreme cases, and when they do, they’re set just slightly below 0. Sweden’s central bank, for example, set their rates at -0.25% in 2009, whereas the European Central Bank set it at -0.1% in 2014. 

Why do economists focus so much on interest rates? 

Interest rates can not only serve as signals, but as tools for the economy’s health. Lower interest rates means people are more willing to borrow money. The cost of taking out a loan is cheaper, and more importantly there’s less money to pay back, meaning the borrower is going to spend more. 

Lower interest rates also tend to create inflationary pressures, because of the increased borrowing, people have more cash to spend, which increases demand. Demand goes up, and so do prices. This is known as demand-pull inflation (see our article on inflation). Also think back to our previous article - when money is loaned out and then deposited into another bank account, this expands the money supply. With lower interest rates, more money is loaned out and as a result, more money is deposited into other bank accounts, thus expanding the money supply. 

So if you ever find yourself in a crippling depression (an economic one, that is) and you want to do your part to get the economy back on its feet, here’s what you do: simply take out a few loans, go on a shopping spree, and hope that everyone else will do the same.