What is an interest rate?

An interest rate is the price to rent money. It is usually a percentage of the amount of money, such as eight percent. For example renting $1,000 might cost eight percent of $1,000 or $80.

Unfortunately, in most countries, one bank, called a “central bank,” is allowed to set the interest rate. However, the interest rate could instead be set by supply and demand. If suddenly more people want to rent money, then the price to rent money would increase. This would encourage more people to rent their money and that would decrease the price to rent money.

When one bank is allowed to set the rental price, then as is the case with all price controls, scarcity or waste develops. If suddenly people want to rent more money and the price does not increase, then new people will not be persuaded to rent their money and all existing money will likely be rented, meaning some people won’t be able to rent money. Conversely, when fewer people want to rent money, and lenders are not allowed to lower their prices, then people who might rent money at the lower price will not have this option.

Low interest rates favor borrowers, not lenders, and high interest rates favor lenders, not borrowers. For example, lowering interest rates to help businesses also harms lenders or savers. In fact, the money that a saver might have made is passed directly to the borrower. If person A was going to rent $1,000 to person B at five percent interest rate, the person A would charge $50. If the interest rate was lowered to three percent, then the price would fall to $30 and the Person A would earn $20 less, while person B would pay $20 less, which is like person B earning $20 more. The $20 was transferred form person A to person B because the interest rate was lowered.

Some will argue that a lower interest rate helps the economy. It only helps part of the economy and harms another part of the economy. Lowering the interest rate forces savers to help borrowers.

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