University of Karachi

REPORT ON OVERVIEW OF INTEREST RATE

Course tittle: Financial Markets &

Institutions
Submitted to:
Dr. Zeeshan Atiq
Submitted by:
Sidra Anwar & Yusra Yaqoob
P1556143, P1556177
Contents:
1-Abstract
2-Introduction
3-Definition of interest rate
4-Types of Interest rate
5-Methodology
6-Summary & Conclusion
7-References /Biography
Abstract:
The purpose of this paper is to outline a theoretical framework that can
serve as a starting point for analyzing interest rate behavior in those
developing countries that are in the process of removing controls on the
financial sector and restrictions on capital flows. The approach suggested
here combines elements of models developed for both closed and open
economies; thus it is able to incorporate the influences on domestic
interest rates of foreign interest rates, expected changes in exchange
rates, and domestic monetary developments. An interesting feature of the
model presented is that the approximate degree of financial openness,
defined as the extent to which domestic interest rates are linked to foreign
interest rates, can be determined from the data of the country analyzed.
These results are precisely those expected, given the characteristics of
the respective financial systems.

Key words: (Interest rate, Growth, Inflation)

Introduction:
Interest rate is the price demanded by the lender from the borrower for the
use of borrowed money.

In other words, interest is a fee paid by the borrower to the lender on

borrowed cash as a compensation for forgoing the opportunity of earning
income from other investments that could have been made with the cash.

Thus, from the lender’s perspective, interest can be thought of as an

"opportunity cost’ or "rent of money" and interest rate as the rate at which
interest (or ‘opportunity cost’) accumulates over a period of time. The
longer the period for which money is borrowed, the larger is the interest (or
the opportunity cost).
The amount lent is called the principal. Interest rate is typically expressed
as percentage of the principal and in annualized terms.
From a borrower’s perspective, interest rate is the cost of capital. In other
words, it is the cost that a borrower has to incur to have access to funds.

DEFINITION OF INTEREST RATE:

Interest rate may be defined as,
‘’The proportion of a loan that is charged as interest to the borrower,
typically expressed as an annual percentage of the loan outstanding’’

Interest rates are the cost of borrowing money. Interest rates are normally
expressed as a % of the total borrowed, e.g. for a 30-year mortgage, a
bank may charge 5% interest per year.
Interest rates also show the return received on saving money in the bank or
from an asset like a government bond.

Types of interest rate:

There are different types of interest rates, including variable, fixed,

compound, and simple. Variable, floating, or adjustable rate is offered on
various financial instruments, including credit cards, mortgages, bonds, and
loans. The charges paid by customers vary with fluctuations. For example,
a customer borrows $75,000 from a financial institution. The loan comes
with 6-month LIBOR plus 4 percent. The LIBOR is currently at 2.2 percent.
The customer will pay 6.2 percent in charges or $3,100 within a period of 6
months. At the end of the period, the LIBOR goes up to 3 percent, and the
borrower pays 7 percent. He owes $3,500 for the next 6 months. The
LIBOR is 1.3 percent during the second year, and the borrower owes 2,650
during the first 6 months.

Interest because it is added to the outstanding balance. Fixed interest

loans come with fixed installments, meaning that borrowers pay the same
amount on a monthly basis. This gives them a degree of security because
they can budget and save for their monthly payment. Banks offer different
financial products with fixed interest, including loans, mortgages, and lines
of credit, credit cards, HELOCs, and others. There is also a difference
between compound and simple interest. The latter refers to a method for
calculating the charges on a loan. They are calculated by multiplying the
number of periods by the principal amount and by the rate of interest.

METHODOLOGY:
Factors affecting the level of Interest Rate:
Interest rates are typically determined by the supply of and demand for
money in the economy. If at any given interest rate, the demand for funds
is higher than supply of funds, interest rates tend to rise and vice versa.
Theoretically speaking, this continues to happen as interest rates move
freely until equilibrium is reached in terms of a match between demand for
and supply of funds. In practice, however, interest rates do not move freely.
The monetary authorities in the country (that is the central bank of the
country) tend to influence interest rates by increasing or reducing the
liquidity in the system.

Broadly the following factors affect the interest rates in an economy:

Monetary Policy: The central bank of a country controls money supply

in the economy through its monetary policy. In India, the RBI’s monetary
policy primarily aims at price stability and economic growth. If the RBI
loosens the monetary policy (i.e., expands money supply or liquidity in the
economy), interest rates tend to get reduced and economic growth gets
spurred; at the same time, it leads to higher inflation. On the other hand, if
the RBI tightens the monetary policy, interest rates rise leading to lower
economic growth; but at the same time, inflation gets curbed. So, the RBI
often has to do a balancing act. The key policy rate the RBI uses to
inject/remove liquidity from the monetary system is the repo rates.
Changes in repo rates influence other interest rates too.

Growth in the economy: If the economic growth of an economy picks

up momentum, then the demand for money tends to go up, putting upward
pressure on interest rates.

Inflation: Inflation is a rise in the general price level of goods and

services in an economy over a period of time. When the price level rises,
each unit of currency can buy fewer goods and services than before,
implying a reduction in the purchasing power of the currency. So, people
with surplus funds demand higher interest rates, as they want to protect
the returns of their investment against the adverse impact of higher
inflation.
As a result, with rising inflation, interest rates tend to rise. The opposite
happens when inflation declines.

Global liquidity: If global liquidity is high, then there is a strong chance

that the domestic liquidity of any country will also be high, which would put
a downward pressure on interest rates.

Uncertainty: If the future of economic growth is unpredictable, the

lenders tend to cut down on their lending or demand higher interest rates
from individuals or companies borrowing from them as compensation for
1`the higher default risks that arise at the time of uncertainties or do both.
Thus, interest rates generally tend to rise at times of uncertainty. Of course,
if the borrower is the Government of India, then the lenders have little to
worry, as the government of a country can hardly default on its loan taken
in domestic.
 Impact of interest rates:
There are individuals, companies, banks and even governments, who have
to borrow funds for various investment and consumption purposes. At the
same time, there are entities that have surplus funds. They use their
surplus funds to purchase bonds or Money Market instruments.
Alternatively, they can deposit their surplus funds with borrowers in the
form of fixed deposits/ wholesale deposits.
Changes in the rate of interest can have significant impact on the way
individuals or other entities behave as investors and savers. These
changes in investment and saving behavior subsequently impact the
economic activity in a country.

Effect of lower interest rate:

Lower interest rates make it cheaper to borrow. This tends to encourage

spending and investment. This leads to higher aggregate demand (AD) and
economic growth. This increase in AD may also cause inflationary
pressures.
In theory, lower interest rates will:

 Reduce the incentive to save. Lower interest rates give a smaller

return from saving. This lower incentive to save will encourage consumers
to spend rather than hold onto money.
 Cheaper borrowing costs. Lower interest rates make the cost of
borrowing cheaper. It will encourage consumers and firms to take out loans
to finance greater spending and investment.
 Lower mortgage interest payments. A fall in interest rates will
reduce the monthly cost of mortgage repayments. This will leave
householders with more disposable income and should cause a rise in
consumer spending.
 Rising asset prices. Lower interest rates make it more attractive to buy
assets such as housing. This will cause a rise in house prices and therefore
 rise in wealth. Increased wealth will also encourage consumer spending as
confidence will be higher. (wealth effect)

 Depreciation in the exchange rate. If the UK reduce interest rates, it

makes it relatively less attractive to save money in the UK (you would get a
better rate of return in another country). Therefore there will be less
demand for the Pound Sterling causing a fall in its value. A fall in the
exchange rate makes UK exports more competitive and import more
expensive. This also helps to increase aggregate demand.

Overall, lower interest rates should cause a rise in Aggregate Demand (AD)
= C + I + G + X – M. Lower interest rates help increase (C), (I) and (X-M)

Effect of raising interest rates:

The Central Bank usually increase interest rates when inflation is predicted
to rise above their inflation target. Higher interest rates tend to moderate
 economic growth. They increase the cost of borrowing, reduce disposable
income and therefore limit the growth in consumer spending. Higher
interest rates tend to reduce the rate of economic growth and inflationary
pressures.
Higher interest rates have various economic effects:

1. Increases the cost of borrowing. With higher interest rates, interest

payments on credit cards and loans are more expensive. Therefore this
discourages people from borrowing and spending. People who already
have loans will have less disposable income because they spend more on
interest payments. Therefore other areas of consumption will fall.
2. Increase in mortgage interest payments. Related to the first point
is the fact that interest payments on variable mortgages will increase. This
will have a significant impact on consumer spending. This is because a 0.
5% increase in interest rates can increase the cost of a £100,000 mortgage
by £60 per month. This is a significant impact on personal discretionary
income.
3. Increased incentive to save rather than spend. Higher interest
rates make it more attractive to save in a deposit account because of the
interest gained.
4. Higher interest rates increase the value of a currency (due to
hot money flows. Investors are more likely to save in British banks if UK
rates are higher than other countries) A stronger Pound makes UK exports
 less competitive – reducing exports and increasing imports. This has the
effect of reducing aggregate demand in the economy.
5. Rising interest rates affect both consumers and firms.
Therefore the economy is likely to experience falls in consumption and
investment.
6. Government debt interest payments increase. The UK currently
pays over £30bn a year on its national debt. Higher interest rates increase
the cost of government interest payments. This could lead to higher taxes
in the future.
7. Reduced confidence. Interest rates affect consumer and business
confidence. A rise in interest rates discourages investment; it makes firms
and consumers less willing to take out risky investments and purchases.

Therefore, higher interest rates will tend to reduce consumer spending and
investment. This will lead to a fall in Aggregate Demand (AD).
If we get lower AD, then it will tend to cause:

 Lower economic growth (even negative growth – recession)

  Higher unemployment. If output falls, firms will produce fewer goods
and therefore will demand fewer workers.
 Improvement in the current account. Higher rates will reduce
spending on imports, and the lower inflation will help improve the
competitiveness of exports.

AD/AS diagram showing impact of interest rates on AD

Effect of higher interest rates – using AD/AS diagram.

Market Interest Rates and Bond Prices:
Once a bond is issued the issuing corporation must pay to the bondholders
the bond's stated interest for the life of the bond. While the bond's stated
interest rate will not change, the market interest rate will be constantly
changing due to global events, perceptions about inflation, and many other
factors which occur both inside and outside of the corporation.
The following terms are often used to mean market interest rate:
 Effective interest rate
 Yield to maturity
 Discount rate
 Desired rate

When Market Interest Rates Increase:

Market interest rates are likely to increase when bond investors believe that
inflation will occur. As a result, bond investors will demand to earn higher
interest rates. The investors fear that when their bond investment matures,
they will be repaid with dollars of significantly less purchasing power.

Let's examine the effects of higher market interest rates on an existing

bond by first assuming that a corporation issued a 9% $100,000 bond when
the market interest rate was also 9%. Since the bond's stated interest rate
of 9% was the same as the market interest rate of 9%, the bond should
have sold for $100,000.

Next, let's assume that after the bond had been sold to investors, the
market interest rate increased to 10%. The issuing corporation is required
to pay only $4,500 of interest every six months as promised in its bond
agreement ($100,000 x 9% x 6/12) and the bondholder is required to
accept $4,500 every six months. However, the market will demand that
new bonds of $100,000 pay $5,000 every six months (market interest rate
of 10% x $100,000 x 6/12 of a year). The existing bond's semiannual
interest of $4,500 is $500 less than the interest required from a new bond.
Obviously the existing bond paying 9% interest in a market that requires
10% will see its value decline.

When Market Interest Rates Decrease:

Market interest rates are likely to decrease when there is a slowdown in

economic activity. In other words, the loss of purchasing power due to
inflation is reduced and therefore the risk of owning a bond is reduced.

Let's examine the effect of a decrease in the market interest rates. First,
let's assume that a corporation issued a 9% $100,000 bond when the
market interest rate was also 9% and therefore the bond sold for its face
value of $100,000.

Next, let's assume that after the bond had been sold to investors, the
market interest rate decreased to 8%. The corporation must continue to
pay $4,500 of interest every six months as promised in its bond agreement
($100,000 x 9% x 6/12) and the bondholder will receive $4,500 every six
months. Since the market is now demanding only $4,000 every six months
(market interest rate of 8% x $100,000 x 6/12 of a year) and the existing
bond is paying $4,500, the existing bond will become more valuable. In
other words, the additional $500 every six months for the life of the 9%
bond will mean the bond will have a market value that is greater than
$100,000.
Relationship Between Market Interest Rates and
a Bond's Market Value:
As we had seen, the market value of an existing bond will move in the
opposite direction of the change in market interest rates.

 When market interest rates increase, the market value of an existing

bond decreases.
 When market interest rates decrease, the market value of an existing
bond increases.
 The relationship between market interest rates and the market value
of a bond is referred to as an inverse relationship. Perhaps you have
heard or read financial news that stated "Bond prices and bond yields
move in opposite directions" or "Bond prices rallied, lowering their
yield..." or "The rise in interest rates caused the price of bonds to fall."
If you were the treasurer of a large corporation and could predict interest
rates, you would...

 Issue bonds prior to market interest rates increasing in order to lock-

in smaller interest payments.
If you were an investor and could predict interest rates, you would...

 Purchase bonds prior to market interest rates dropping. You would do

this in order to receive the relatively high current interest amounts for
the life of the bonds. (However, be aware that bonds are often
callable by the issuer.)
 Sell bonds that you own before market interest rates rise. You would
do this because you don't want to be locked-in to your bond's current
interest amounts when higher rates and amounts will be available
soon.
Interest free banking:
Interest & Capitalism:
Whole of the capitalism is based upon interest and interest is accorded as
a payment of use of capital. As, if anybody lends some money to other he
losses the money for the period for which the money had been lent.
Therefore, whatsoever is given to the lender in the form of compensation is
called interest. But with the passage of time so many problems are
emerging which are attributed to interest. As they are:

Unequal Income Distribution:

If we analyze capitalistic economics we find that the income inequalities go
on to increase. Rich people borrow on interest and lead on interest.
Therefore, their incomes go to increase. Whereas the lion share of
domestic population consists of the small farmers, shopkeeper, and
household and salaried person people. They have to borrow from banks,
Mahajan’s and land lords. These people are unable to pay back the
principal amount ever.

Economic Fluctuations:
The banks advance excessively in order to earn interest. All this leads to
create inflation. On the other hand, the banks realize that their own
reserves have gone down because of excessive lending.
Public Goods and the Fields Regarding Social Welfare:
One is well aware of with Macroeconomics that investors while investing
likes to equate the IRR with ERR. If IRR>ERR investment will be made in
that project. If IRR<ERR investment will not be made in that very project.
But in each society there are so many projects which are concerned with
social welfare.

International Economics:
The capitalism has created income inequalities not only at domestic level,
but also at international level. The international economics and monetary
arrangements are playing an important role to widen this gap between poor
and rich nations.

Interest and Islam:

The word “Riba” has been used for interest in Islam. This represents
‘Addition’. It means the increase in the wealth or money of the person who
has lent. If the borrower failed to pay back the principal amount it granted at
some new and higher rate of interest. It means that before Islam the
excessive amount charged by the Arabs against their principal amount has
been accounted Riba in Islam. Along with the arrival of Islam Riba has
completely banned.

Alternative OF Interest (Riba):

The alternate of interest will have to satisfy following measures:
The alternate of interest must not lead to discourage the saving and
investment.
Because of budget deficit and easy monetary policies the value of money
is falling rapidly. As the result, the people have tendency to convert the
cash into gold, grains and land etc.
.The alternative of interest must be acceptable to other countries and
international institutions. If the alternate of interest is accepted by other
countries no issue will rise.

INTEREST FREE BANKING IN PAKISTAN:

Three steps to elaborate:
 It is clearly mentioned in The Holy Quran that there is no scope of
Riba. Moreover, Riba represents all the types and forms of interest ( it
means that it is wrong to say that interest charged by the commercial
banks is different from the Riba which was prevailing in Arabs).
 In Islam the interest on consumption loans is prohibited on the ground
of sympathy and pity. The co-operations between capital and
entrepreneur in Islam have been established on the basis of profit
and loss.
 In Pakistan due to the illiteracy and income tax fear business class
maintain two separate systems of accounts.
They are discussed below:
 Services charges
 Indexation of bank deposits and advances
  Leasing
 Investment auctioning
 Bai-muajjal
 Hire-purchase
 Financial on the basis of normal rate of return

CONCLUSION:
This study explain the effect of the interest rate risk, rising and falling effect
on an economy. It can be used to help a central bank reach on inflation
target, it based ln a quantity of interest rate and quality of interest rate risk.
It can be determined of interest rate and earnings o the business.
Most of the investors are not satisfied with the earnings on deposit in
the firm of interest. Changing in trade of interest also keep away
investors from banking.
As we discuss monetary policy in factor affect the interest rate in an
economy. This policy involves for preparing a plan, aimed,
objectives, price stability etc.
Short term interest rate have emerged as operative target or
instruments of monetary policy.
Interest rate paly ab important role to invest in banking institutions,
and banker guaranteed that the amount after maturity is gain on
deposit that is interests which investor was earning on deposit. So it
is a challenge that has to be faced by banking institution as well as
investor of bank.

References:
www.infoline.com/article/news/factors-affecting-level-of-
interest-rate-4907147014_1.html
www.economicshelp.org/macroeconomics/monetary-
policy/effect-raising-interest-rates/
https://www.economicshelp.org/blog/3417/interest-
rates/effect-of-lower-interest-rates/
https://www.economicshelp.org/blog/4868/economics/interest-
rates-definition/
Article: Factor effecting level of interest rate
Shodhganga.Inflibnet.in
Book(Monetary Eco & Finance)/Author : A. Hamid.
Shahid.(professor of economics) Year of Publishing 2010