What's an interest rate?

In an economy, interest rates serve really important purposes.

Firstly, interest rates represent the cost of borrowing funds. When you want to borrow money from the bank, you’ll have to pay an interest rate and this will determine the size of the repayments on your loan.

And if you think about it: higher interest rates, higher repayments, so people are less willing to borrow big stacks of money.

Secondly, interest rates are the reward for saving money in the bank. When you deposit savings in your bank account, the bank gives you an incentive for this behaviour — paying you interest, on your savings, at an interest rate.

Think about this one. The higher the interest rate on savings, the more likely people are to save their money. In terms of their incomes, people can spend or save (and pay tax). Generally, the more they save, the less they can spend (because people’s incomes are generally fixed at a point in time). Think about the identity Y=C+S, where Y is income, C is consumption and S is saving.

So in an economy interest rates function as a cost and a benefit. And, as I’ve suggested, interest rates influence people’s behaviour and the level of economic activity.

Let’s take an example here. In the Australian economy, the official level of interest rates is reduced. This means that interest rates, generally, are lower across the whole economy. This will discourage saving as people earn a lower interest rate on their savings; as a result, they will spend more. In addition, lower interest rates mean lower repayments...so there will be more borrowing and investment in the economy.

As a result, the economy is likely to grow.