Inflation: Factors Driving Interest Rates

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Page count 10
Word count 2872
Read time 10 min
Subject Economics
Type Essay
Language 🇺🇸 US

The commencement and sustenance of any business enterprise require capital as well as other funding to smoothly operate in the prevailing high competitive business environment. However, this may not be easy to realize given the scarcity of financial resources exhibited in the business market. Therefore, investors including companies and even governments have no option except to borrow finances from lenders to fund capital projects as well as enhance the expansion of their businesses. Such borrowing follows an agreement between the borrower and the lender where the former is required to pay an extra fee when repaying the borrowed sum for using the money. This constitutes the interest and the rates are always calculated in percentages after a year. Interest rates are important indicators of economic status and are key components in the prevailing market prices. Interest rates not only reflect on the demand and supply for funds but also on the default risk. It is therefore noteworthy that increases in the interest rates greatly affect the borrowers as well as prices in the financial market.

Interest rates in a country are determined by a variety of factors prevailing in that economy. To begin with, levels of inflation in a country have a substantial effect on the interest rates. The general increase in the price of items over a certain period constitutes Inflation. Though it may be positive at times, inflation adversely affects the interest rates in an economy. High inflation results in the reduction of real money value as well as other monetary items in a given period. Inflation is therefore worth taking note of since it can affect investments especially when investors are cautious of possible inflation in the future. The driving forces behind interest rates in an economy may include economic development which brings forth changes in the financial environment thereby inducing a very interactive response in the whole financial system (D’Arista, 1994).

Besides, advancement in technology also affects the interest rate in an economy. According to D’Arista (1994), such innovations in an economy are important as they provide investors with efficiency and convenience in the execution of their trading activities. Communication technology for instance enhances changes through increased volatility, volume, as well as the importance of trading activities in the whole financial system ( D’Arista, 1994). This, therefore, implies that the financial environment in such an economy is favorable hence interest rates charged by the banks on the money borrowed are equally fair. Besides, new economic development enhances the integration of markets that were previously separated by differences in regulatory treatments as well as geographical location. Previously, the financial system created an avenue for unequal and ineffective treatment of financial institutions thereby negatively impacting the lending and borrowing activities by the banks which in turn affect the interest rates adversely. Finally, increased interdependence between the local and foreign financial market is another factor enhancing the trading activities thus ensuring interest rates are controlled. (D’Arista, 1994).

The demand and supply of credit in a country affect the interest rates. When demand for credit heightens within a specified period, banks tend to raise the interest rates on the money they lend out to the borrowers. In such a scenario the supply of such credits is low. However, when the supply of credits extended to borrowers surpasses the demand for such funds then interest rates are destined to fall.

The government is a key player in the determination of interest rates in an economy. At the outset, levels of taxes levied by the government on interests gained by banks may significantly impact the rate of such interests. The lenders would want to recover the losses incurred when such taxes are imposed. They can only achieve this by increasing the interest rates on funds lent to the borrowers thereby increasing the general interest rates in the financial system. Besides, the government may also influence interest rates through monetary policy established in the country. Unlike in economically advanced nations such as the U.S where independent institutions are mandated to implement the monetary policies, such activity is executed solely by the government in some developing economies. This policy controls the money supply, availability as well as rate of interest in an attempt to foster the growth and stability of an economy. Monetary policy can either be an expansionary policy where it increases the supply of money in an economy and thus used to counter unemployment in a country during the recession through reduction of interest rates or contractionary policy which reduces the supply of money in an economy thereby raising the rates of interests in the economy (Handa, 2000). Generally, the government through monetary policy controls the supply of money in the economy by setting the interest rates.

Additionally, risks have a direct effect on the rates of interest in the economy. It is always considered that high-risk investments produce higher returns compared to safer investments. Most of the lenders charge a risk premium on the investment they consider risky (Brigham & Ehrhardt, 2008). This however depends on individual lenders. Risk-averse lenders usually charge higher premiums on the money they lend out when such investments have a 0.5 probability of default during their operation thereby elevating the interest rates. According to Brigham & Ehrhardt (2008), risk-neutral lenders would charge moderate interest rates fairly below those charged by the aforementioned lender. Finally, risk-loving lenders usually charge the least premium on their investments. Unfortunately enough, most lenders always fall in the first category of risk-averse individuals ( Brigham & Ehrhardt, 2008).

Generally, the prevailing interest rates in the economy are affected by other equally significant issues such as the country’s financial and political stability, the activity of the foreign exchange market, general economic conditions as well as the demand for debt securities by the foreign investor.

The prevailing interest rate in the economy is a vital phenomenon as far as economic growth and stability are concerned. Viable measures should therefore be installed by all the concerned parties including the government, banks as well as investors in the private sector to ensure that it is kept at a reasonable level.

The fisher hypothesis provides for the stability of real estate rates in the long run. This implies that the actual interest rates and inflation in the economy are in harmony. This is an approximation equation but exhibits a minor difference from the correct equation. It is given by:

n = i + r


  • i is the inflation rate
  • n is the actual/nominal interest rate and
  • r is the real interest rate.

According to the equation, the nominal interest rate which is the actual interest rate without any alterations and inflation rate move in unison thereby ensuring the stability of the real interest rate in the long run. This is important since the nominal interest rate is usually used in the calculation of almost all debts during payments. Since payment of debts encompasses the estimation of interest rates, the Fisher equation would therefore help forecast interest rates (Handa, 2000).

Real interest rates are also used to demonstrate an actual increase in the value as well as the number of returns accruing from the effects of inflation. According to Handa (2000), certain savings products and bonds pay a real interest rate because they have payments that are related to an inflation index. Investors should use real returns when considering inflation to help them in planning their financial investments. Instead of utilizing financial forecasts entailing the effects of discounts and inflation using discount nominal rate as an approach to discount cash flow, investors should forecast in real terms followed by the adoption of real interest rates in the process of discounting. Generally, such initiative shreds inflation therefore important during the valuation process. It has provisions for the estimation of the expected rate of inflation from the yield curve when incorporated in the structure of interest rate. Handa (2000) argues that in the short-run real interest rates are reduced by an increase in the supply of money while the inflation resulting from anticipations raises the nominal interest rate (Handa, 2000). The Fisher equation can also be used to forecast the exchange rate between the local and foreign currencies.

An increase in the rates of real interest may have a direct impact on the credit demand by investors which would, in turn, alter the way money supply is used. Investors will resort to consumption in such scenarios but change to savings when the demands fall following a fall in the real interest rates. This implies that the international capital will be following financial markets that offer higher real interest rates compared to those that offer lower rates thereby inducing exchange rates (Handa, 2000).

It is always vivid from an economic perspective that a certain amount of money has to be available in an economy at a given time. The total amount of such money constitutes the money supply. Money supply in an economy is very vital in a variety of ways. To begin with, it has potential effects on the general prices levels and subsequent inflation. As the money supply increases in an economy, the levels of prices tend to go up and vice versa. Due to the increased dependence on monetary policy as a means of controlling inflation, increased money supply has resulted in a subsequent increase in the price inflation in the economy (Handa, 2000). Moreover, the money supply is equally important as it has possible effects on the business cycle. The business cycle involves the fluctuations in the economic or production activity within a specific period usually many years or several months. When such supplies of money are affected say through monetary policy, fluctuations in the aforementioned activities are imminent. According to Keynesian economics, insufficiency in macroeconomic results may occur due to certain decisions by the private sectors within the economy thereby affecting the business cycle. He, therefore, proposes public sector intervention by all means including utilization of actions of monetary policy to alleviate the output (Handa, 2000).

Due to the above-mentioned importance of money supply, it is therefore wise for an economy to control it. Such activity is carried out by a variety of authorities including the central banks as well as governments in some developing countries where independent systems to control money supply have not been developed. Federal Reserve is such a money supply control authority in the U.S whose establishment way back in 1913 was done following heightened financial panic among the citizens of America. The Federal Reserve controls the supply of money in many ways. At the outset, the authority is mandated to regulate money supply by expanding and contracting the supply as warranted by the prevailing conditions. It does this through the monetary policy actions that are stipulated in the Federal Reserve Act. Moreover, the authority being the lender of last resort in the U.S may as conditions may warrant, reduce or increase the interest rates thereby controlling lending which in turn affects the total amount of money circulating within the economy (Meltzer, 2007). Additionally, in situations where banks and other financial institutions experience short-term needs as a result of unexpected withdrawal or fluctuations in deposits, Federal Reserve intervenes to provide liquidity thereby controlling the money supply within the economy and eliminating unexpected fluctuations of supply and demand (D’Arista, 1994).

Besides, Federal Reserves controls the money supply in the economy through purchasing and selling of securities depending on the requirements of the financial market currently prevailing in the economy (Handa, 2000) According to Handa (2000).

The Federal Reserve is mandated by the U.S congress to carry out check clearing activity across all financial institutions countrywide to not only ensure efficiency and equitability of the check-collection system as well as provide elastic currency. Such currency is important in the control of the money supply as it shrinks and expands to meet the demands of the financial market in the country.

The Federal Reserve was established way back in 1913 by congress to address bank runs and financial panic that was heightened in 1907 across the U.S. The authority however expanded and modified its roles and responsibilities to encompass a variety of functions aimed at addressing the financial problems as they arise. Such changes in roles and responsibilities, as well as the structure of the authority, were a result of various economic factors including the great depression of 1929 that adversely affected the economies of several nations of all calibers; both rich and poor (Bauer & Geoffrey 2009). The two researchers admit that these technological changes have enhanced smooth delivery of services by the authority as well as controlled the financial stability of the U.S. Firstly; the enactment of the clearing checks Act followed by its operation in 2003 payment methods have transformed the old paper method to an up-to-date electronic system. Checks are currently advancing as a result of such changes hence it is not only convenient but also competitive (Bauer & Geoffrey 2009). According to Bauer & Geoffrey 2007, such changes are not innovative but also efficient in service delivery by the concerned authority. Second, due to advances in information technology the authority has also adopted modern payment methods including the use of debit cards, the online banking as well as credit cards which are more preferable to the use of cash (Bauer& Geoffrey, 2009).

In situations where there are limited money supplies in an economy below the required amount, the relevant authority such as the central bank or government intervenes to restore such supplies. The authorities can do this through a branch of monetary policy known as expansionary money policy. This policy seeks to increase the amount of money supply in the affected economy. The expansionary monetary policy reduces interest rates and is usually used to curb unemployment rates during an economic recession. It also produces higher growth and employment in the short run but increased inflation in the long run (D’Arista, 1994). However, Keynesian economists question the effectiveness of monetary policy in influencing the real economy. They agree that economic variables such as price interest rates and levels can be affected by the monetary policy but assert that the clarity with which the policy affects variables of employment and income is not demonstrated. Policymakers pursue it coz economic agents will adjust their wage and price expectations upward to reflect the expansionary policy (D’Arista, 1994).

Derivative securities including swap transactions are difficult to analyze using the ordinary risk measures since they exhibit asymmetrical price distribution in the financial market. As a means of managing risk in the interest rate swap, an investor is therefore needed to establish a short hedge swap position to hedge long positions given the fact that the inverse proportionality of changes in swap value to changes in the value of the security hedged is witnessed.

An individual holding a fix-rate position together with other counterparty is required to simultaneously ovate the positions to a reputable and licensed clearinghouse. Entering into a swaption agreement would help mitigate the risks that are always associated with such payment agreements. Collateral agreements involving the posting of the margins are used to cover the future anticipated exposure to risks including failure by the other party to honor payment of the swap. Moreover, swaption hedges the investor from possible downside risks emanating from the transaction (Handa, 2000).

Swap analysis involves the systematic analysis of transactions in the financial market where similar liabilities or assets are exchanged to extend or shorten maturities to maximize the financial cost. The status of the financial market including the general pricing of goods and services as well as the physical market characteristics are analyzed here.

For any nation to realize economic stability and growth, a suitable financial environment has to be created. At the outset, issues affecting the success of any business enterprise are varied and therefore all the stakeholders in the business industry need to be involved in an attempt to enhance economic stability and prosperity. All business ventures need capital to start as well as operate. These finances may not be easily accessible due to barriers in the financial system brought about by either economic strains or poor regulatory measures in place. It is therefore significant that the financial institutions extend a helping hand to the borrowers by creating favorable terms of lending including fair interest rates on the borrowed sum. This is only possible when the lenders receive a fair share of a favorable financial environment to impose fairer interest rates on the loans. On the other hand, other factors that may hamper the borrower’s ability to purchase goods and services such as a high inflation rate should also be addressed to realize the business dream. Inflation entails the general rise in price levels of goods and services in a country and may be caused by the increase in money supply in such states.

Reference List

Bauer, W. & Geoffrey, R. (2009). The Check Is Dead! Long Live the Check! A Check 21 Update. Fed publishers. Web.

Brigham, E. & Ehrhardt, M. (2008). Financial management: theory and practice. 12th Ed. Cengage Learning.

D’Arista, W. (1994). The Evolution of U.S. Finance: Federal Reserve monetary policy. M.E. Sharpe.

Handa, J. (2000). Monetary economics. Routledge. Web.

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EduRaven. (2022, March 16). Inflation: Factors Driving Interest Rates. Retrieved from


EduRaven. (2022, March 16). Inflation: Factors Driving Interest Rates.

Work Cited

"Inflation: Factors Driving Interest Rates." EduRaven, 16 Mar. 2022,


EduRaven. (2022) 'Inflation: Factors Driving Interest Rates'. 16 March.


EduRaven. 2022. "Inflation: Factors Driving Interest Rates." March 16, 2022.

1. EduRaven. "Inflation: Factors Driving Interest Rates." March 16, 2022.


EduRaven. "Inflation: Factors Driving Interest Rates." March 16, 2022.


EduRaven. 2022. "Inflation: Factors Driving Interest Rates." March 16, 2022.

1. EduRaven. "Inflation: Factors Driving Interest Rates." March 16, 2022.


EduRaven. "Inflation: Factors Driving Interest Rates." March 16, 2022.