Interest is the reward for capital. An interest rate is the cost of borrowing money. It could also been as the compensation for the service and risk of lending money. The following are factors which determine interest rates:
- Supply and Demand: Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.
- Inflation: Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they are paid in the future.
- Government: The government has a say in how interest rates are affected. The government often makes announcements about how different monetary policies will affect interest rates.