What is meant by Interest?

Interest is the cost of borrowing funds. It is the amount charged in percentage expressed as Interest rate. In other words, interest is the cost of renting money.

Suppose Mr. A borrows Rs. 50,000 at an interest rate of 5% p.a. Hence, the interest charged for borrowing the funds at the interest rate given will be Rs. 50,000*5% = Rs 2500/-

What factors determine interest rates?

Interest Rate is used to regulate Inflation by the central banks. Inflation is the continued increase in the general price levels of an economy. On the other hand; interest is the cost of borrowing funds. The explanation given below will make you understand that the primary factor affecting interest rate is inflation.

Let us discuss two main situations:

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.