In the financial world, interest is the cost associated with borrowing money. If you borrow $100 at an interest rate of 10 percent, you have to pay back $110. The extra 10 percent represents the interest charged by the lender, and i$10 s the price you pay for borrowing the money. The cost of borrowing, or the interest rate, can go up or down, depending on how much money is available. Governments often use interest rates to react to adverse economic conditions, or as a proactive way of trying to steer national and international economic performance in a specific direction.

The supply level of any commodity is usually the main cause of fluctuations in its price. Institutions, such as banks that lend money, use the funds they receive from savers to lend to borrowers. The interest paid to savers is typically less than the interest the banks charge borrowers. When money supply is slow, such as when other investments like stocks and shares provide a higher return, banks increase the interest rates paid to savers to solicit more deposits. Because the banks, in effect, are paying more for the money they use to lend to borrowers, they have to charge the borrowers more, meaning interest rates rise. When lending institutions have more money than borrowers want to borrow, the lending institutions have to compete for business, so they lower interest rates to attract new borrowers.

Inflation

Inflation occurs when prices are rising in an economy. This can happen when there is more demand for goods and services than the economy can supply. Suppliers are then able to charge higher prices. When this occurs, people find that they can no longer afford the goods they could previously buy. This is known as cost-push inflation. People typically react to cost-push inflation by demanding higher wages. Manufacturers then increase their prices even more to pass on the cost of increased wages to consumers. This combination of cost-push and wage inflation adds to inflation.

Government central banks typically use interest rates to try to control inflation. By moving interest rates up, the demand for borrowing is reduced and so does spending by householders with mortgages. Mortgages typically cost more when central bank interest rates increase. This reduction in spending reduces demand in the economy, and reduced demand deters price rises. The need to control inflation is a major reason why governments raise interest rates.

Economic Slowdown

When an economy is slowing down, such as when industrial and commercial output falls, or the growth of that output begins to slow down, interest rates tend to fall. During times of economic slowdown, producers tend to postpone projects involved in the expansion because they are uncertain whether they can achieve the sales needed to justify these projects. When companies reduce spending in this way and reduce the need to borrow, lenders have to lower their interest rates to compete for business from potential borrowers. In a pure market, interest rates should fall to a rate at which producers find it cost-effective to borrow again.

Currency Values

The currencies of countries with successful economies based on international trade tend to rise in value against other currencies. This happens because other countries use their own currency, or foreign currencies that they hold, to buy the successful currency. The United States’ dollar traditionally has been held by foreign countries. Many commodities, such as oil, are traded in dollars. When a country’s currency has a high value, importers in that country need to spend less of the currency to purchase goods from overseas, but exporters find it more difficult to sell to overseas customers because the overseas customers have to spend more of their own currency to buy goods from the exporters. One way that governments attempt to control the value of their currencies is by raising or lowering interest rates. When a country lowers its interest rates, the value of it’s currency typically falls in value compared to other currencies. This makes that country’s exports more attractive, while making imports less attractive. Interest-rate falls are used by governments to improve the balance of trade that their countries have with the rest of the world.

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