Role of Interest Rates

Interest is a return to the capital as a factor of production. Savings is the basis of investment and capital formation. Investment is a function of interest rate and the quantum and directional flow of investment determine income. Interest Rate and interest income have a vital role in the economy and plays a significant part in the growth dynamics of the economy. Capital formation and capital accumulation are very much dependent upon the level and rate of savings and investment in the economy.

The savings and investment in the economy which are influenced by the interest rates are the real economic variables. It is these savings and investment activities of the real sector which are influenced and facilitated by the flow of funds from the financial system development.

Interest rates are a key determinant of business cycles in emerging market countries (EMCs). Over the last decade, many EMCs have coped with frequent and large changes in the interest rates that they face in international financial markets. These changes have usually been associated with significant business cycles fluctuations.  Periods of low interest rates are typically coupled with relatively rapid economic expansion, whereas times of high interest rates are often associated with lower growth.

Interest rate has diverse roles in the economy such as a reward to capital which is a factor of production, a return to saving and a cost to investment and an instrument of monetary policy for credit .These and other aspects of interest rates are relevant for policy makers.

At the macro level, interest is a reward to the capital, which is a factor of production. In the developing economy, capital formation and capital accumulation are of vital importance to economic development. Interest rates influence both savings and investment in the economy and serve a vital role for the mobilization of savings. Besides, interest rate has a role in the allocation of investment funds as between different uses. Thus, in addition to influencing their cost, and availability of funds from the supply side, interest rates also influence the quantum of investments from the demand side and thus determine the income and employment in the economy.

While the overall household sector savings are mildly influenced by interest rates, household sector savings in the form of bank deposits are highly sensitive to interest rates. It would, therefore, appear that investment rates have a positive role in the savings mobilization, particularly with regard to savings in the form of bank deposits. Interest rates is an important consideration for a modern finance manager in taking investment decisions

Interest rates are the measure of cost of borrowing. The interest rates of a country also influence the foreign exchange value of its own currency. Interest rates are taken as a guide in investments into shares, debentures, deposits, real estates, loan lending etc. The interest rates in different market segments due to the following reasons:

• Risk: Borrowers carrying high risk will pay higher rates of interest than the borrowers with less risk .
• Size of Loan: The higher amounts of deposits carry higher interest than small deposits.
• Profit on re-lending : Financial intermediaries make their profits from re-lending at a higher rate of interest than the cost of their borrowing.

Nominal and Real Rates of Interest

• Nominal rates of interest are the actual rates of interest paid.
• Real rates of interest are the rates of interest adjusted for the inflation. The Real rate is, therefore, a measure of the increase in the real wealth, expressed in terms of buying power, of the investor or lender.

The Real rate of interest is calculated as