The interest rate concept

This topic is very interesting and important for the overall understanding of the way how our economy is functioning. Where should I start?

Let us start from the two basic cases when interest rate occurs. The first case is when you deposit some money in the bank. You expect the bank to pay you some interest, don't you? It is a similar case when you give your money to a company and it pays you a dividend.

The second case is when you take a loan from the bank. Then the bank expects from you to repay your liability plus some interest in addition. This is the banking business actually. Or at least many people see it this way.

But ask yourself what do you achieve when you take the loan and pay the interest rate to the bank or what do you achieve when you save money and expect interest rate on your savings?

You simply transfer consumption from one period to another one!

When you save money, you transfer potential current consumption to a future period. To do this sacrifice the bank must pay you interest. This is the transfer price. Without this incentive you would probably spent your money immediately without much consideration.

Let us imagine the opposite example. You want to buy a car but you don't have all of the money saved. You have two options. First you could wait until you save the whole purchase price or second you could take a car loan from the bank and have it now. In the second case you must pay some interest to the bank. This is the price because you haven't waited so long but have taken the car immediately.

So, think of the interest rate as the price for transferring your consumption from one period to another one. When you want to transfer your future consumption today you need to pay interest to your lender and when you save money and transfer in this way your current consumption to the future you receive interest rate or dividends on the saved amount.

Now, do you remember what the central banks have done after the crisis in 2008 in order to bring the economy again to normal functioning? They have pumped a lot of money to the market and in the same time they have reduced the interest rate drastically. Why? Because they want to stimulate the consumers to transfer their future consumption to the current period when it is more needed for the health of the economy. And in the same time, they want to discourage the consumer to save money and to transfer the today's consumption to the future.

During boom times of the economy the central bank does exactly the opposite. It rises the interest rate in order to stimulate us to reduce the current consumption and to transfer it to the future because it is doing already harm to the economy in the current period. With the higher interest rate, we will get more for our savings from the bank. The incentive is higher. From the other perspective would you take the car loan mentioned above if you have to pay 20% interest rate? High interest rate has two incentives in the same time. The first one is the incentive to save money and the second one is the higher price for the borrowing of money with which we transfer our future consumption to the current period.

The interest rate is powerful tool in the hand of the central banks. They use it to regulate the consumption and the business activity in the economy. When it is running too fast and there is a danger of overheating the central bank will increase the interest rate to dump the consumption and the business activity. When the economy is not running to its potential the central bank is reducing the interest rate to make the consumption easier.

So, think of the interest rate as the transfer price for your consumption.

© 2021 Svetoslav Deltchev