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Global Interest Rates: The Central Banks usually set the interest rate in line with the global trends. In case interest rates are going up globally, the Central Bank prefers to raise the cash rate in order to retain global competitiveness in attracting foreign funds.
Similarly, higher interest rates are also used as a tool to attract overseas capital from investors and influence the country’s exchange rate.
Money Demand and Money Supply: Interest rates are primarily driven by the demand and supply for money in an economy. If at any given cash rate, the demand for funds exceeds the supply of funds, the interest rates typically rise and vice versa, to balance the money supply and demand dynamics.
Inflation: One of the most important macroeconomic indicators, inflation, is closely monitored by Central Banks to decide on interest rate movements. In fact, interest rate is often used by monetary authorities as a tool to control inflation and establish balance in an economy.
If the level of inflation is high in an economy, Central Bank prefers to raise the interest rates so as to increase the cost of borrowings. This process makes the borrowing expensive, keeps a check on demand and controls the money supply, thereby bringing inflation in the target range.
Government Borrowing: At times when the Government expenditure surpasses its revenue, resulting in a fiscal deficit, the Government resorts to borrowing from the Central Bank. The quantum of this borrowing induces a rise in interest rates amid burgeoning demand for money.
While these factors drive interest rates at a broader level, the rates charged by individual banks on customers’ borrowings or loans depend on several other factors, including credit score, Loan-to-Value, loan size, credit history, debt ratio, employment type, length of loan and available documentation.
How Interest Rates Play a Role in Monetary Policy?
Central banks use monetary policy as an important tool to increase or decrease the availability of credit in an economy, which further affects aggregate demand and consumer spending.
To stimulate consumer spending and business activities, Central Banks often employ an expansionary monetary policy by decreasing the level of interest rates, in order to foster the money supply. The key objective of an expansionary policy is to fuel economic growth. For instance, multiple Central Banks reduced their interest rates to record low levels during COVID-19 outbreak to bring sustenance in their respective economies.
On the other hand, Central Banks use contractionary monetary policy by increasing the level of interest rates to control inflation and keep a check on money flowing into the economies. A surge in the interest rates makes borrowing expensive, discouraging overall demand and bringing inflation under check.
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