What Is Structure of Interest Rate?
Interest rates are directly correlated to the performance of the world economy. Government officials craft monetary policy to manage national economies by influencing the banking system. At the micro-level, investors and private consumers should have some appreciation for the connection between interest rates and the economy before making financial decisions.
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Identification
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Interest rates are referred to as the "cost of money." Lenders that offer capital for investment are compensated with interest payments from borrowers.
Features
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Interest rates measure risks. Lenders demand additional compensation for lending capital to riskier borrowers. Investors also expect to earn a premium that is higher than the rate of inflation to make any transaction worthwhile. U.S. Treasuries, which have been described as "risk-free" investments, are a benchmark for evaluating interest rates.
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Asset Prices
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Interest rates help to establish asset prices in a free-market economy. Prospective home buyers often will refuse to buy new homes because of high interest rates; housing prices then must fall to attract buyers. Additionally, high interest rates attract investors to the safety of interest-bearing bonds--at the expense of riskier common stock ownership.
Intervention
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Central banks intervene through open market transactions and management of banking reserve requirements to affect interest rates and the economy. Higher interest rates slow growth and manage inflation. Lower interest rates are intended to counter recessions and promote growth by encouraging additional borrowing. The Federal Reserve Board is the central bank for the United States.
Warnings
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Do not base your personal economic decisions strictly on interest rates. Interest rates are but one piece of a bigger puzzle; and government action to stabilize the economy is rarely immediate.
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- Photo Credit Image by Flickr.com, courtesy of Perpetual Tourist
