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An economy is a vast interconnected system of businesses, workers and customers. No one group, business or agency can possibly know enough about an economy to manually control all its aspects. Knowledge must be disseminated through other means. Interest rates are how information about the supply and demand of money is transmitted through an economy.
What is Interest?
Interest is the price of money. Since various amounts of money fluctuate wildly on a daily basis, interest is impossible to express as a regular price, like the price of a good or service. Instead, interest is expressed as a percentage rate. For example, 1% means that a certain sum of money carries the additional price of 1% annual interest.
How Interest Rates Work
Interest rates work in two ways. They tell borrowers and lenders where loans can be profitably made, and they tell savers and investors where their money can earn the most profit. A higher rate means the price of money is more expensive in one area of the economy. Money flows in from other sectors to take advantage of the higher rate until the rate lowers to reflect the greater supply of money.
The price of money is calculated by compound interest or simple interest. Simple interest is the percentage rate of the principal sum applied over a period of time. Compound interest is far more important. As the interest accumulates on the principal, further interest is calculated on the basis of the increased amount. The sum grows of it's own accord, without any help.
Compound interest is what attracts investors to put their money in stocks, bonds and other investment products. This is also why borrowers and lenders pay so much attention to interest rates. More compound interest means more profit for the lender and more expense for the borrower. Interest rates communicate the supply of money relative to the demand of money throughout the economy.
The Federal Reserve
The Federal Reserve, the central bank of the United States, oversees the supply of money. The Federal Reserve is responsible for closely monitoring several key economic indicators and adjusting interest rates accordingly. This central bank can change interest rates throughout the economy, giving it enormous power. The Federal Funds Rate is the primary mechanism the Federal Reserve uses to accomplish this action. (http://www.house.gov/jec/fed/fed/fed-impt.htm)
Raising of the funds rate results in money being taken out of the economy, creating higher interest rates. Lowering the funds rate accomplishes the opposite. Through this simple action, the Fed can dictate the economic actions of millions of people. The money supply relative to the supply and demand of goods can create inflation, which is rising prices, or deflation, which is falling prices.
Prosperity and Interest
Interest rates have been demonized as unnecessary extra costs. In reality, they are vital to the health of an economy. Money is a good like food and cars. Interest rates tell consumers the best places to earn the most profit. They also help the economy become more efficient.
