Determinants Of Interest Rates

Interest rate can be defined as the return to the owner funds or the cost of borrowing money which is lent out or invested. It is usually expressed or indicates as a percent per annum of the amount of money invested, lent or borrowed (Reserve Bank of Australia, 2012). Today, interest rates are tools used for managing the economy as well as to stimulate the economy in times of peak seasons. This is done so by countries central bank whereby they would supply an amount of money with a specific interest rate to attain a certain target rate. 

There are generally two types of interest rates, the real interest rate and nominal interest rate. As Mofatt (2004) stated that, “real interest rates are the interest rate that has accounted for inflation while nominal interest rates are the interest rate that has not been accounted for inflation”. Also, interest rates can influence the future expectation of the level of inflation either by short-term interest rates or long-term interest rates. The differences between short-term interest rates and long-term interest rates are that the short-term interest rates are kept lower to entice the borrower for a shorter period of time as compared to a long-term interest rate. Besides, a nation’s reserve bank usually measure, controlled and influenced the short term interest rates, unlike the long-term interest rates whereby it serves as an economic indicator and can’t be controlled or measured by a nation’s reserve bank. Generally, a low rate of interest rate would usually stimulate the borrowers or business. Because of such low rate, it will be an incentive to actually spend more rather than saving it in financial institutions. This could result in an increase in the level of spending and will cause inflation in the long run. Vice-versa, a high rate of interest rate would discourage borrowers from borrowing. 

Due to such high rate of interest, this will be an incentive to actually save more rather than spending it. And thus leading to a decrease in the level of spending which would, in turn, keep the level of inflation low. “This is why lower interest rates tend to lead to a higher level of inflation while higher interest rates tend to lead to a lower level of interest rate” by (Najwa, 2005). Furthermore, since the interest rate is the cost of borrowing money. It is usually the compensation for the risk and service of lending money. Without it, individuals would not be able to save or even lend their cash as both of which it requires an opportunity that is deferred in the present world to spend. Thus, the purpose of this report is to brief the shareholders about the major determinants of interest rates and anticipate the changes of the interest rate in the upcoming 12 months in 2012 to 2013 financial period.

Determinants of interest rates

One of the major determinants of interest rates is the monetary policy conducted by the Reserve Bank of Australia or RBA. The RBA is the central bank of Australia whereby its role is to stabilise its currency and also to conduct the monetary policy (Reserve Bank of Australia, 2012). Before the RBA conducts the monetary policy, they will first determine whether to change the interest rate and it will consider factors such as the level of economic activity, the balance of payment, exchange rate and employment that can maintain the level of inflation within a specific range (Viney, 2012). It can be anticipated that the interest rate will be adjusted from periods if those factors are moving significantly with the values that the RBA considers appropriate. Looking on to how interest rates change the levels of inflation. Firstly, Inflation can be defined as the rise in the prices of goods and services. Also, inflation is usually caused by a high level of economic activity. As the level of inflation rises, the purchasing power of consumers reduces. Thus, one of the objectives of the RBA is to maintain an inflation rate target rate of 2% to 3%. Due to the increasing rate of inflation, the RBA will then decide to implement the monetary policy to reduce its level of inflation by tightening the monetary policy that is by increasing the interest rates (Viney, 2012). Besides, the aim of tightening the monetary policy is to decrease the rate of spending in the interest-sensitive area in the economy. When the spending rate is reduced, the role of the suppliers in the marketplace would then weaken.

However, if the economic activity is low, the RBA would then loosen its monetary policy by reducing the interest rates. As interest rates are reduced, consumers would then tend to spend more than saving and this will basically smoothen out the level of spending which then improves the economic activity. Moreover, the RBA will generally increase the interest rate if the rate of inflation is over the business cycle or outside its target range as mentioned above. Similarly the RBA will also increase the interest rate if the rate of growth in the gross domestic product grows excessively, or the current account of the balance of payments is in deficit, or the associated debts level are expanded too quick and if the currency is under boundless downward pressure in the foreign exchange market (Viney, 2012). Thus, as mentioned earlier, an increase in inflationary expectation and an increase in the level of economic activity would cause interest rate to rise and this is known as the income effect on interest rates. For the inflation effect on interest rates, it happens when the economy slows down leading to an upward pressure on prices and it will allow the interest rate to fall. Interest rate could then be anticipated to fall independently of monetary policy. Likewise, the monetary policy operated by the RBA would change in response to conditions. As Viney (2012) suggested, “it is necessary to know that a change in the monetary policy settings will affect the economic condition which in turn affects interest rates generally”.

References list

Mofatt, M 2004, ‘Understanding and calculating interest rates’ The Finance Times, vol. 15, no. 8, pp. 431-535.

Najwa, S 2005, A Review of How Interest Rate Affects The Economy, Inflation News, p. 12.

Reserve Bank of Australia 2012, Reserve Bank of Australia, viewed 4 October 2012, <http://search.rba.gov.au/search?q=interest+rate&output=xml_no_dtd&client=newRBA&proxystylesheet=newRBA&>.

Viney, C 2012, Financial Institutions, Instruments and Monetary Policy, 6th ed, McGraw-Hill Education, Australia.