An interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they

borrow from a lender (creditor). Specifically, the interest rate (I/m) is a percentage of principal (P) paid a
certain number of times (m) per period (usually quoted per year). For example, a small company borrows
capital from a bank to buy new assets for its business, and in return the lender receives interest at a
predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest
rates are normally expressed as a percentage of the principal for a period of one year.
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interest-rates are a vital tool of monetary policy and are taken into account when dealing with variables
like investment, inflation, and unemployment. The central banks of countries generally tend to reduce
interest rates when they wish to increase investment and consumption in the country's economy.
However, a low interest rate as a macro-economic policy can be risky and may lead to the creation of
an economic bubble, in which large amounts of investments are poured into the real-estate market and
stock market. This happened in Japan in the late 1980s and early 1990s, resulting in large unpaid debts
to the Japanese banks and the bankruptcy of these banks and causing stagflation in the Japanese
economy (Japan being the world's second largest economy at the time), with exports becoming the last
pillar for the growth of the Japanese economy throughout the rest of the 1990s and early 2000s. The
same scenario resulted from the United States' lowering of interest rate since the late 1990s to the
present (see 20072012 global financial crisis), substantially by the decision of the Federal Reserve
System. Under Margaret Thatcher, the United Kingdom's economy maintained stable growth by not
allowing the Bank of England to reduce interest rates. In developed economies, interest-rate adjustments
are thus made to keep inflation within a target range for the health of economic activities or cap the
interest rate concurrently with economic growth to safeguard economicmomentum.
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Reasons for interest rate changes [edit]
Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under
normal conditions, most economists think a cut in interest rates will only give a short term gain in
economic activity that will soon be offset by inflation. The quick boost can influence elections. Most
economists advocate independent central banks to limit the influence of politics on interest rates.
Deferred consumption: When money is loaned the lender delays spending the money
on consumption goods. Since according to time preference theory people prefer goods now to goods
later, in a free market there will be a positive interest rate.
Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of
money buys fewer goods in the future than it will now. The borrower needs to compensate the lender
for this.
Alternative investments: The lender has a choice between using his money in different
investments. If he chooses one, he forgoes the returns from all the others. Different investments
effectively compete for funds.
Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, die, or
otherwise default on the loan. This means that a lender generally charges arisk premium to ensure
that, across his investments, he is compensated for those that fail.
Liquidity preference: People prefer to have their resources available in a form that can immediately
be exchanged, rather than a form that takes time to realize.
Taxes: Because some of the gains from interest may be subject to taxes, the lender may insist on a
higher rate to make up for this loss.

Step 1
Match maturities of borrowings and maturities of loans. You can apply this to your own finances by considering the length of time you
will need the money you intend to borrow and locking in an interest rate that you can afford over the entire period. You may have an
opportunity to refinance your loan at a lower rate later, but you will not experience an upward adjustment of your interest rate if market
rates increase.
Step 2
Invest in securities with maturities shorter than two years. You can easily use this strategy to protect the value of your investments. Your
risk is that interest rates will rise, causing the dollar value of your bonds to drop. A moderate rise in interest rates does not materially
affect the prices of maturities under two years, and interest on money market funds will fluctuate up with any rise in interest rates, so the
shorter the maturities, the better protected you are.
Step 3
Use derivatives and interest rate swaps to hedge the interest rate risk. This is a complex undertaking for an individual, but if there is
enough money at stake, you can use futures on U.S. Treasury bonds to hedge your interest rate exposure. Most large commercial banks
can provide such services for large accounts.
Step 4
Buy floating rate investments if you do not have enough money to qualify for professional cash management. These would include
Treasury Inflation Protected Securities (TIPS), which fluctuate in interest rates in keeping with inflation. These can be purchased
throughTreasuryDirect.gov.
Step 5
Pay off revolving lines of credit monthly. For individuals, this means not carrying floating-rate loans during periods of increasing interest
rates, because the interest on those loans will float upward with market rates.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies. During
the last half of the twentieth century, the countries with low inflation included Japan,
Germany and Switzerland, while the U.S. and Canada achieved low inflation only
later. Those countries with higher inflation typically see depreciation in their currency
in relation to the currencies of their trading partners. This is also usually accompanied
by higher interest rates. (To learn more, see Cost-Push Inflation Versus Demand-Pull
Inflation.)
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries. Therefore, higher
interest rates attract foreign capital and cause the exchange rate to rise. The impact of
higher interest rates is mitigated, however, if inflation in the country is much higher
than in others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest rates tend to
decrease exchange rates. (For further reading, see What Is Fiscal Policy?)
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest and dividends.
A deficitin the current account shows the country is spending more on foreign trade
than it is earning, and that it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign currency than it receives
through sales of exports, and it supplies more of its own currency than foreigners
demand for its products. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests. (For more,
see Understanding The Current Account In The Balance Of Payments.)

4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects
and governmental funding. While such activity stimulates the domestic economy,
nations with large public deficits and debts are less attractive to foreign investors. The
reason? A large debt encourages inflation, and if inflation is high, the debt will be
serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt,
but increasing the money supply inevitably causes inflation. Moreover, if a
government is not able to service its deficit through domestic means (selling
domestic bonds, increasing the money supply), then it must increase the supply of
securities for sale to foreigners, thereby lowering their prices. Finally, a large debt
may prove worrisome to foreigners if they believe the country risksdefaulting on its
obligations. Foreigners will be less willing to own securities denominated in that
currency if the risk of default is great. For this reason, the country's debt rating (as
determined by Moody's or Standard & Poor's, for example) is a crucial determinant of
its exchange rate.

5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports rises
by a greater rate than that of its imports, its terms of trade have favorably improved.
Increasing terms of trade shows greater demand for the country's exports. This, in
turn, results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports
rises by a smaller rate than that of its imports, the currency's value will decrease in
relation to its trading partners.

6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes
will draw investment funds away from other countries perceived to have more
political and economic risk. Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to the currencies of more stable
countries.

Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its
investments determines that portfolio's real return. A declining exchange rate
obviously decreases the purchasing power of income and capital gains derived from
any returns. Moreover, the exchange rate influences other income factors such as
interest rates, inflation and even capital gains from domestic securities. While
exchange rates are determined by numerous complex factors that often leave even the
most experienced economists flummoxed, investors should still have some
understanding of how currency values and exchange rates play an important role in
the rate of return on their investments.