Olan McEvoy
Research expert covering the European Union for society, economy, and politics.
Get in touch with us nowInterest rates form a key part of central banks’ monetary policy toolkit – that is, the central bank may adjust its key interest rate in an attempt to increase or decrease the amount of credit in the economy. After a period of historically low interest rates in the period following the Global Financial Crisis of 2008-09, many central banks began to raise interest rates in the aftermath of the COVID-19 pandemic in an attempt to lower inflation.
What are interest rates?
Interest rates are essentially the cost of receiving money. When a borrower takes out a loan, they make the promise to pay back the full amount which they originally borrowed, plus the interest accumulated on the debt over the period of the loan. Similarly, when a depositor puts their money in a savings account, they can withdraw this full amount at a later date, along with the extra interest earned on their deposit. Most people tend to think about interest rates when they are looking to take out a mortgage, get a car loan, or finance other expenses such as university tuition.There is not one set interest rate in the economy at any one time, but rather many interest rates. The rate of interest for a specific loan will be dependent on a number of factors, such as the central banks’ policy interest rate, the length of the loan, the type of borrower, and the perceived risk of the money not being paid back by the borrower. The risk of default can cause particularly large deviations in the rate of interest charged on borrowing, with a relatively safe loan, such as those given to sovereign governments, charging a vastly lower rate than those for risky loans, such as consumer spending loans.
How do interest rates work?
The interest rate quoted by the financial institution when a loan is taken out or money is deposited will be the nominal interest rate – that is, the percentage of the total charged, which is not adjusted for inflation. If inflation is taken into account, then the real interest rate is considered, which measures the growth in the real value of the loan or deposit. If inflation is high and interest rates do not rise accordingly, then there may be negative real interest rates on loans, meaning that the real value of the loan will decline year on year. The interest rate on a loan paid each year is referred to as the Annual Percentage Rate (APR), while for the interest earned on an investment or savings account with a financial institution it is referred to as the Annual Percentage Yield (APY).A further distinction in interest rates can be made between simple interest and compound interest. Simple interest rates are the most straightforward of the two, as they are simply a percentage of the amount borrowed, multiplied by how long it will take to pay the loan back. Compound interest is more complicated, as the borrower pays interest on the interest incurred during each period. In simpler terms, this means that at the end of each period, usually one year, the interest incurred over the period is added to the original amount borrowed, and then the interest owed for the following period is calculated from this total.
Who has control over interest rates?
Interest rates are partially determined by economic conditions, such as the supply of savings, business confidence, or inflation expectations, which are largely out of the control of private or public actors. Central banks, however, set their own interest rate which they charge private banks for borrowing and pay these banks for their deposits, which in turn has a strong effect in determining the rates at which banks charge to consumers and businesses. Most central banks are legally mandated to follow a specific goal with their monetary policies, with a common goal being to maintain price stability and to prevent excessive inflation. This means that if the central bank believes that inflation is too high, given their mandate, they will raise interest rates to slow the growth of credit in the economy.Conversely, when inflation is too low, which may risk a deflationary spiral, the central bank can lower its key interest rate in order to spur economic activity, by making credit cheaper. Many of the world’s leading central banks are independent institutions (such as the Federal Reserve in the U.S., the European Central Bank, and the Bank of Japan), meaning that they are not under the direct control of politicians. Decisions about the key interest rates should therefore be informed by the goal of meeting their mandated targets, rather than by overtly political concerns (such as increasing GDP growth).
Interest rates and the wider economy
The impact of interest rates on domestic borrowing and spending is quite clear, as lower interest rates incentivize firms and individuals to borrow for investment, consumption, and sometimes even speculation. In an interconnected, globalized world, however, no country’s economy is fully separated from any other. This means that rising interest rates in one country may have a knock-on effect for others. The mechanism which this is transmitted through is the exchange rate of a country, as, holding everything else equal, an increase in its interest rates will cause the appreciation of a country’s currency. For instance, the Federal Reserve’s decision to raise interest rates in 2022 has been linked to an appreciation in the U.S. dollar, which increases U.S. purchasing power, but decreases the amount of U.S. exports that consumers in other countries can buy.Developed countries’ central banks deciding to raise interest rates can also be an issue for developing countries, who are more likely to borrow money in dollars, euro, or yen. The Volcker Shock, when the Federal Reserve raised interest rates to a historic high of around 19 percent, was associated with the severe debt crises which many developing countries suffered from in the early 1980s. Some economic commentators have warned about the increasing risks brought on by currency devaluations in Latin America in the wake of the Fed's rate hikes since 2022. On the other hand, when faced by inflation or other macroeconomic risks, developing countries may have to raise interest rates to protect their currencies from depreciating or to prevent capital flight.
