The Role of Interest Rates



The Role of Interest Rates

Interest rates play a key role in the economy because they affect our decisions as consumers about both saving money and borrowing money. The higher the interest rate, the less likely we are to borrow Interest rates influence the decisions made by businesses to invest by purchasing new machinery expanding or building a new plant. They also influence the value of the Canadian dollar internationally, as higher interest rates attract more foreign investors and, therefore, increase the demand for Canadian dollars. The budgets of governments are affected as veil because the more they have to spend on interest on their debts, the less money they have available for social or other programs.

Different Types of Interest Rates

Different types of interest rates exist, serving a variety of purposes. It is important to grasp that they all tend to rise and fall together over the long run. You might be familiar with the interest rate charged on credit cards. (The issue of excessively high credit card interest rates is examined in the Economics in the News feature on page 272.) Another important lending rate is the prime rate, which is the lowest rate of interest a financial institution offers to its best customers (such as large corporations).The prime rate serves as a benchmark for the other lending rates that the institution offers to its other customers. If approved for a loan, a customer will be offered an interest rate that is a certain number of points “above prime,” a number that varies depending on the customer’s credit—worthiness, the amount of the loan, the term of the loan, and the amount of other business that the individual does with the institution.

Another type of interest rate is the Bank rate. This is the rate of interest charged by the Bank of Canada for loans made to the chartered banks and other financial institutions. If the Bank rate rises, financial institutions will usually raise the rates they charge their borrowers; if it falls, they lower the rates. The Bank rate is set at 0.25 per cent above the overnight rate target. One of the most important factors built into all interest rates is the allowance for inflation, called the inflation premium. Let’s examine how this works.

Suppose you borrow $1000 from your parent or guardian with the understanding that you will repay the loan in one year. During that year, Canada’s general price level rises 4 per cent. This means that the $1000 you borrowed is worth 4 per cent less when you repay the loan, or $960 [$1000 — ($1000 X 4%) = $960].Your parent or guardian receives dollars that are worth less in purchasing power than they were when he or she granted you the loan. You have benefited because you are repaying dollars worth less than when von borrowed them. Inflation hurts lenders— your parent or guardian, in this case—and benefits creditors. The only way to avoid the effects of inflation is to set the interest rate at a level that compensates for the loss of purchasing power.

If, for example, your parent or guardian was aware of inflation’s damaging effect, he or she should charge you a rate of interest that would cover the loss in purchasing power—an inflation premium of 4 per cent. You would be required to repay $1040 [$1000 + ($1000 X 4%) $1040]. Your parent or guardian, however, doesn’t know for sure that inflation will raise prices by 4 per cent. If it stands at only 2 per cent, your parent or guardian would come out ahead. If it stands at 5 per cent, however, he or she would lose.

Financial institutions that lend money build an inflation premium, based on future inflation estimates, into all the rates they charge borrowers. The interest rate that includes an inflation premium plus an allowance for risk and creditworthiness is called the nominal interest rate. If the expected rate of inflation is subtracted from it, we have the real rate of interest on the loan. Here is a simple formula demonstrating the relationship:

Real Rate of Interest = Nominal Rate of Interest-Expected Rate of Inflation

Risk + Inflation Inflation

If you borrow from a chartered bank and it allows 2 per cent for the risk of granting you a loan plus 4 per cent for inflation, the nominal rate would be 6 per cent. If the rate of inflation for the year turned out to match the predicted 4 per cent, the real rate of interest for the bank would be 2 per cent. We see, then, that inflation raises interest rates, making borrowing more expensive. When inflation rates are low as they were in the early 2000s, Canadian interest rates are low as well.

Questions:

1) Define the following:

a) Prime rate

b) Real rate of interest

c) Bank rate

d) Nominal Interest rate

2) Why does interest rate “above prime” vary for different customers?

3) How is the Bank rate set?

4) A chartered bank offers a one year loan at “3 points above prime” Prime is 4%.

a) What is the nominal interest rate?

b) If expected inflation is 3% for next year, what is the real rate of interest?

c) Suppose inflation rises 4%. What is the real rate of interest?

5) Explain why lenders build an inflation premium into their lending rates?

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