Letters – The role of an interest rate in the modern financial system

Kasika gift

The relationship between the interest rate, savings and investments is important in determining and forecasting a country’s economic growth potential and its ability to finance its own investments.

Interest rate is defined as the amount charged on financial assets, or alternatively a return on financial assets for a specific period expressed in terms of percentage. There is a wide variety of interest rates in the market because there are a variety of different financial assets with maturity periods, issuers, risk of the financial asset, tax on returns of financial assets, the liquidity of the underlying financial asset, etc. right now.

Faced with all the different financial assets above, their interest rates tend to react in more or less similar ways in response to monetary policy or any other disturbance in the financial system. Given their general tendencies and the similarities in their reactions, the analysis of an interest rate can be captured on a single representative financial asset, because interest rates have more in common than they differ. Among the other financial assets, the most representative is the interest rate of a Treasury bond. Treasury bills are short-term government securities with a maturity of less than one year, denominated within three months, six months and a maximum of one year maturities from the date of issue. Being issued by the government, treasury bills are considered risk-free because the government often honors its obligations with the backing of the central bank, provided they are denominated in a local currency that the central bank has the mandate to print, like the Namibian dollar. .

The risk-free nature of treasury bills is an important quality that makes them theoretically interesting for analyzing the attractiveness of market participants, and therefore it is an ideal representative of all other interest rates in the financial market.

Also, the interest rate of a short-term debit note serves as a benchmark for other interest rates as they are mainly sold by commercial banks to their central bank when they need liquidity. As such, it is the rate at which the central bank provides liquidity to the banking sector through open market operations and at the discount window.

This interest rate is commonly referred to as the discount rate or the repurchase rate (repo rate) for short. Banks add a certain percentage markup on the repo rate as a fee for their customers. The rate applied by the bank to its customers is called the prime rate. It is the rate at which commercial banks extend credit to the non-banking public, as well as to other banks in need of liquidity reserves.

Overall, other interest rates tend to move in the direction of the repo rate. A longer-term interest rate revolves around the return expectations of short-term interest rates plus a risk premium. The general direction/movement of an interest rate is captured by the structure of the interest rate. The structure of the interest rate curve is used to predict the effect of disturbance and crises on the general interest rate. The repo rate is one of the policy tools through which central banks exert their influence on the banking sector and the financial system as a whole in order to achieve their monetary policy objective, and thus influence the macroeconomic situation. Other policy tools under the full control of central banks are the level of liquidity supply. As a monopoly issuer of cash, the central bank has the mandate to manipulate the level of liquidity in the financial system to the desired target level. The interest rate as a policy tool acts through its influence on the supply and demand for loanable funds from commercial banks to the non-banking public. When the interest rate is high, borrowers are discouraged from borrowing, depending on the expected returns on their potential investment since they will have to repay the principal of the debt plus the interest rate to the bank, whereas at Conversely, a lower interest rate stimulates more borrowing on the part of the non-banking public.

The ability of commercial banks to extend credit to the non-banking public is limited by the amount of reserve cash reserves in their possession, as deposit holders are mandated to convert their deposits into cash at all times, and banks must therefore be able to meet the demands of their customers. By manipulating the supply of liquidity, the central bank indirectly influences the ability of banks to grant credit to their customers.

The interest rate is determined by the scarcity of cash reserves rather than the scarcity of cash/loanable funds. The relevance of the availability of loanable funds applies to the non-banking public rather than commercial banks since the central bank is readily available to provide liquidity to banks in need at the prevailing interest rate.

Being a return on investments, the interest rate is one of the defining incentives that determine the level of saving and investment. Savings are income that has not been spent, or deferred future consumption. On the other hand, investments are the purchase of goods for future consumption or the purchase of financial assets with the hope of generating a positive return in the future.

2022-11-11 Staff reporter

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