Interest Rate

Economics and Currency

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Curriculum Content

Leading/Coincident/Lagging: Lagging Economic Indicator
Type: Rate

Summary: The interest rate is a lagging indicator targeted by Central Banks to control inflation and deflation levels. The interest rate controls the rates that banks lend money to each other overnight. Central banks can set a “Reserve Limit”, a required percentage of capital to have on hand. Banks lend if above reserves, borrow if below reserves. The interest rate determines the lending rates. Central banks use open market operations to move market rates towards the interest rate. There are several tools that can be used to push interest rates (Removing Cash from Economy by Selling Government Bonds, Adding Cash to Economy by Buying Government Bonds, Raise Depository Fund Rate to reduce Bank Liquidity, and Lower Depository Fund Rate to increase bank liquidity). Ultimately, higher rates raise all other available interest rates in the financial sphere while a lower rates reduce all other rates.

Interest Rate (IRATE)	Change Versus Previous
As IRATE falls, RGDP grows faster.	IRATE lowered, economy grows quicker.
As IRATE rises, RGDP growth slower.	IRATE raised, economy grows slower.
Interest Rate falls, Inflation accelerates as money is cheaper to acquire.
Interest Rate rises, Inflation slows as money is expensive to acquire.
If IRATE is very low, Central Bank likely to…	Hyperinflation Risks, so raise Interest Rate.
If IRATE is very high, Central Bank likely to…	Deflation Risks, so lower Interest Rate.
All information is general, not absolute. Invest using total economy, not one indicator.
RGDP = Real GDP

Impact on Local Currency: A lower rate means money is “cheap” to borrow versus future repayment, bringing more loans, more available currency, and higher inflation. The cheap currency also powers a debt-driven expansion in Real GDP. Foreigners seeking bond returns will avoid bonds from low rate currencies, avoiding purchases lowers the value. Higher Interest rates make money more expensive to borrow, reducing the rate of inflation, and slowing Real GDP gains. Bond investors prefer higher interest rates and buy bonds (provides loans to) from a high-interest rate economy (relative to other interest rate economies available). They must buy currency to buy bonds, which helps the exchange rate.