What factors infulence intrest rates?

Question

and what are the effects on increases/ decreses

thanks

Answer 1

In the United States there is the federal reserve that is responsible for controlling the money supply through monetary policy.  Their tools include increasing or deacreasing reserve requirements in banks, changing the discount rate, or open market operations.  Changing reserve requirements is the Fed (short for Federal reserve) telling banks that they must keep more or less money in bank reserves.  If the banks must hold more money, then they can loan out less, which decreases the amount of money that can be made from loaning out, which will in turn decrease the money supply.  The discount rate is the interest rate that the Fed charges banks when they borrow from the Fed.  The federal funds rate is the rate that the Fed sets that banks are allowed to charge each other in interest when borrowing from each other.  Changing the rates will affect the money supply.  Increasing either rate will decrease the money supply and decreasing either rate will increase the money supply.  Another tool of the Fed is open market operations.  This is where the Fed buys and sells bonds on the open market.  This directly influences the money supply where as the other two tools have a delay time.  Also, changing the reserve requirment is rarely used by the Fed (like only a few times I think in their history).  So now we know how the money supply in the U.S. is affected.  So what does that have to do with interest rates?  Well, with an increased money supply, the interest rate will drop, because there is more available money, so people have more to invest.  With more money, money is cheaper (inflation) and less scarce.  When money is less scarce, it is easier to loan to people.  When there is more money, and it is easier to loan, then the interest rate drops.  When there is less money, the interest rate increases.  This can been seen in the U.S. recently.  When the Fed increased the money supply, it decreased in interest rate.  Hope this helps.

Answer 2

Imagine that economics is defined as chemistry of wealth. Imagine change of wealth from one form to another and call them economic reactions. Apply Law of Mass Action of chemical reactions to this economic reaction:

Liquidity -------> Investment

You will find that interest rate is the equilibrium constant for the above reaction. If liquidity increases, interest rates fall and if investments increase, interest rates increase.

This is the reason why when interest rates fall the prices of government securities rise. Liquidity can also be construed here as savings. If savings increase interest rates drop. If savings/liquidity are hard to come by interest rates rise.

If there is inflation, the manufacturers think of investing money in production of goods and this results in increase in investment. As stated earlier, this increase in investment results in increase in interest rates.

Mathematically,

Present value of wealth + Inflation = Future value of wealth

Present value of wealth + Interest = Future value of wealth

Present value of wealth + Time = Future value of wealth.

We can deduce:

Inflation = interest = Time.