Interest Rates and Markets

In a way financial markets are like time machines. They make it possible to borrow against tomorrow's income and spend it on items today and to use the savings of the past to prosperity in the future. A key factor that determines the cost of borrowing from future income or the returns that one might get upon investing today is the interest rate.

If one takes a loan from the bank the bank becomes the lender, on the other hand if one were to deposit a certain amount in a bank the depositor becomes a lender to the bank. In either case the lender expects some return, one can even consider the interest to be a sort of rent for using the capital. More formally the interest rate is the amount a lender charges for the use of assets expressed as a percentage of the principal. Hence the interest rate can also be looked at as the cost of borrowing or the reward of investing.

So what happens if the interest rate changes? If the interest rate were to increase it would mean that the cost of borrowing is increasing this in turn will force the people to spend less and in especially fragile economies this could cause recession. On the other hand if interest rates were to be reduced the cost of borrowing would reduce and people would spend more and take up riskier investments. Such investing could lead to stocks and bonds being evaluated higher than they should be (due to the high demand) which would set up these markets to fail.

There is a special case where interest rates can be negative, obviously they were always a mathematical possibility but over the last few years a few countries like Japan and Sweden have actually seen this in reality. So what does this negative interest rate imply? Since the rate is negative, the borrowers get rewarded and the lenders bear the cost. In such a topsy turvy world people will tend to hoard cash as putting one's savings in banks would incur a cost. Also products like pension and insurance, that are necessary for a stable economy, will cease to be feasible as the companies that sell these plans will be unable to make a profit out of them. If all this is true then why do the governments set interest rates below zero? Since account holders will have to pay a nominal fee to keep their money in banks, they will be encouraged to spend more. This was initially intended to be used to give short term jolts to struggling economies but now economists are learning to grapple with this for the long term.