These days interest rates and inflation are hot topics, so I wanted to explain these terms, simplified as always.
What is an interest rate?
In simple terms, the interest rate is the cost of borrowing money. For example, if a bank makes a loan of $100 with a 10% interest rate then the bank will receive 110 dollars at the end of the loan's term.
What is the real interest rate?
The real interest rate is the interest rate minus inflation. By using real interest rate, we can estimate the real return when lending money, because the increase in prices of goods and services is accounted for.
What happens when real interest rates are high?
High-interest rates mean that it is expensive to borrow and profitable to lend. Therefore, in a high-interest environment, people will borrow less money, instead, they will lend their money, in most cases to banks in exchange for interest. Because people lend money rather than spend it, they will have less money to spend on goods and services. That will decrease the demand for goods and services, which in turn decreases their prices. That is called deflation and will result in a contraction of the economy: that is when the economy gets smaller because less money is being spent, and fewer goods are produced.
What happens when real interest rates are low?
In contrast to the previous case, low interest means it is cheap to borrow and decreases the incentive to lend. That results in more borrowing, and because people have more money, they purchase more goods and services. The increased demand causes prices to rise, that is called inflation. This causes producers to produce more, and the economy grows.
What is happening right now?
Inflation is good for growth but a steep rise in the cost of living is an adverse effect. Many governments target an inflation rate of around 2% per year. But the inflation in the US is 7.7%. So, the Fed is raising the rates to decrease the inflation rate. The TCMB, on the other hand, is cutting the interest rates even though inflation is around 80%, this makes life hard for many people due to rising costs. Remember this is a very peculiar case and not what most central banks would do.
How do interest rates affect assets' prices?
Interest rates and assets prices generally move in opposite directions, because the supply of money increases demand for assets.
That was a brief overview of interest rates and their effects, I would be happy to answer any Qs in the comments.
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