What is interest? How do Central Banks Increase Interest Rates?

What is the interest? How do central banks increase interest rates? How is the interest rate determined? In this post, we'll look at the Investing.com analysis that answers all of these questions. It is worth noting that; While the most important factor in determining the monetary policies of central banks is inflation, interest is a result of this factor. Briefly, the interest rate is determined according to the risk of inflation.   What is interest? We call "interest" the concept that refers to the return of the borrowed money to the lender and the cost of the borrower to be repaid in the future. For example, if the interest that a 1000 TL borrower will give for 6 months usage is 10 percent, 100 TL is the cost for the borrower, but for the lender (bank) it means profit.   What are the Types of Interest? Nominal Interest: Interest used when borrowing or lending money. It determines the nominal interest rate, real interest and risk premium. Real Interest: Real interest adjusted for inflation is called real interest. To explain with an example; Let the monthly nominal return of your money in deposits at the bank be 10 percent, but if inflation is 12 percent, it means that your money has succumbed to inflation, although you do not actually have earnings. If inflation is 5 percent, your real earnings will be 5 percent. The most important factor in risk premium is the possibility of non-repayment or delayed payment of the debt. Therefore, increasing this possibility means increasing the interest rate, because the risk is high here. This is exactly the case with banks' loans. The longer the maturity rate, the more the refund will be. In addition to these, we also encounter expectations. Hence, the expectation that inflation will rise will bring along an increase in interest rates. Expectations and inflation are the main determinants of interest rates used by banks with their customers. However, it is the job of the central bank to determine the interest in the markets.   What is the Interest Applied by the Central Bank? The interest rate applied by the central bank covers banks. Banks borrow money from the central bank and make repo (selling a security to be bought back after a while) while borrowing. The central bank applies the policy rate to the debt that banks receive through repo, and the CBRT uses a one-week repo rate as the policy rate. One of the most important purposes of the interest applied by the CBRT against this lending transaction is to create a balance in the markets. In other words, there is a healthy and balanced price formation target. Banks do not always ask for loans from the center, such that a bank with excess money can lend to the center and receive interest. The interest rate applied by the central bank to banks is also the determinant of the interest rate that banks will apply to customers. Of course, every bank can keep this rate flexible, depending on customer attractiveness and their own policies, but it does not play a big difference.   So what do the applied interest rates do? At this point, it is necessary to look in terms of borrowers and savings. For the borrower, the low interest rate is a factor that will increase the borrowing appetite. As a result, expenditures will increase and this situation is favorable for investments (enterprise) to be made with low interest rates in the country. However, this may be the case in an economy with low inflation, because if inflation is high in an environment with low interest rates, the will to spend will increase the demand and inflation will increase. High interest, on the other hand, will push the person or organization to save as it will increase the borrowing cost. For those who want to save, low interest is of course not good, but high interest yields a profit. If we look at the reflections of low interest and high interest rates on the economy of low inflation and high inflation conditions; Inflation is a determinant in the issue we have mentioned and if inflation rises, the central bank aims to block this increase by using the method of increasing the interest rate. The purpose of this is to restrict the desire to spend with high interest. If inflation is low in a country, the lower the interest rate will be. Accordingly, domestic investments increase, expenditures increase and savings decrease. If inflation is high in a country, the interest rate is raised to prevent further increase and high interest decreases domestic investments, but increases foreign capital inflows. It also saves money.   Is High Interest Good or Bad? It is not good for an economy with consistently high inflation, and although it increases foreign investor inflow, it seriously hinders domestic growth because domestic investments are reduced, initiatives are cut and borrowing decreases. Looking at the CBRT's monetary policy; We see that there have been many increases in interest rates due to the increase in inflation in recent years. In 2020, the central bank had to raise interest rates again due to the effect of the exchange rate on inflation. The interest rate, which is currently 17 percent, is expected to be preserved at the first MPC meeting of the year. However, as the expectation for inflation to exceed 14 percent in the first quarter of the year is strong, the CBRT is expected to increase the interest rate slightly in the coming period. The first Monetary Policy Committee (MPC) meeting of 2021 will be held on Thursday, January 21 at 2 pm.         Source: Investing.com