Understanding interest rates

Simran, a first year BSc student at the Gokhale Institute writes in with this question:

Why is it that some developed countries have 0% interest rates? How are they sustained and is that a mark of a developed country? Is it good/ bad?

Is it related to their inflation rates? Because that’s the only thing I could think of.

They (the BSc students) will have macro only in the next semester, and I’m sure this question will be dealt with then. (I can’t resist adding that the question of how those classes will be conducted is topmost on my mind right now!)

But how would you go about answering this question when your audience has not been subjected to a semester’s worth of classes in macroeconomics?

The challenge I have set myself is that I will not refer to a single economist, or theory, while answering this question.

So: let’s think of it this way, Simran – you have a hundred rupee note with you, and I need a hundred rupees. So I approach you, and ask if you would be willing to give it to me. We’re both students of economics, you and I, so you quite reasonably ask what you will get in return.

Since I have nothing to give you right now, I say well, how about this: I’ll take a hundred rupees from you today, and give back an amount more than that a year from now.

That excess amount, obviously, is the rate of interest. But how much should it be? You would like two hundred rupees a year from now, and I might propose a hundred and one. Neither one of us is likely to accept the others proposal, and so we start looking for other people to cut a deal with.

You start to look for folks who are open to the idea of borrowing a hundred rupees from you, and returning two hundred (or thereabouts). I, on the other hand, start to look for folks who will lend me a hundred, and accept one hundred and one from me.

We, you and I, are now participants in the financial markets of our country. You are on the lender (or supply) side, and I on the borrower (or demand) side.

If there are a lot of people on Team Suppliers, you guys will find it difficult to find the same number of people willing to borrow. And so some of you might decide to cut the rate at which you are willing to lend. And if these financial markets are efficient – what that means is people are easily able to find out the rate/price at which transactions are taking place – then the rate of interest will come down.

Ask yourself what might happen if there are, instead, a lot of people on Team Borrowers.

Well, during these times, can you imagine a lot of people looking to borrow? I, for one, can’t imagine people wanting to set up factories, buy new TV’s, buy new houses etc. There’s hardly anybody playing on Team Borrowers!

But practically everybody in these financial markets is on Team Lenders! And so rates are going to come down:

In fact, right now, there are so many people on Team Lenders right now, that interest rates are not just down to zero, they may well end up being negative! That’s right, you will have to pay to put money in the bank in some of these economies, and you will be paid if you borrow. Boggles the mind, but true!

And kudos for asking if interest rates are linked to inflation – yes, absolutely. But I’ll take a rain check on answering this question right now, simply because it takes us into really deep waters. Macroeconomists are prone to start squawking indignantly whenever they start thinking about inflation and interest rates (myself included), so this is best left for another day.

But for the moment, here’s the key takeaway: there are far too many people on the lending side, and nowhere near enough folks on the borrowing side, and so the price of this market – interest rates – will fall. More so in developed countries than in developing, perhaps, but they’ll fall the world over.

You’ll be able to power through the videos in this section of the macro class on MRU easily enough.

If you, or anybody else who has seen these videos, has any questions, shoot away!