Unit 3- Mini Projects Project-1

Interest rate is that rate of interest that is paid by a borrower who borrows money from the

lender. The Interest rate is the certain percentage of the principal amount that has been borrowed.

Interest rate are taken into account when dealing with variables like investment, inflation and

unemployment. Here, we will find out whether, monetary factors are the driving force or goods and

capital market disturbances were the major cause of determining the interest rates. The widely used

theories are Keynesian liquidity preference theory and Irving Fisher's theory. Some of the

determinants of Interest Rates are as follows:

Some of the factors involves Supply and Demand, an increase in demand for credit will

surely increase the interest rates while any decrease in demand of loan or credit will decrease the

interest rates. Say, for example one opens a bank account and you are lending money to the bank,

here bank will use this money for investment purpose and will give certain percentage of interest on

the principal amount.

Inflation, also affects the rise or slip of interest rates. If the inflation rate is high in any

economy then the interest rate will definitely rise, the reason behind this is that the lenders will

demand higher interest rates on the money borrowed because the purchasing power has decreased

because of the inflation.

Unemployment plays a very important role in the increase or decrease of the interest rates.

The practice is when the employment rate is high Government reduces the interest rate to boost the

purchasing power, while in times of recession the interest rates are increased because the lenders

know that purchasing power is low this time and as they don't want any defaulters they increase the

rates so that only those people who can manage these sort of interest rates can take loans.

Yield curve is a graphical representative of the term structure of interest rates that plots the

yields of similar-quality bonds against their maturities. The yield curve has three shapes positive,

negative and flat shape.The three main theory that explains why yield curves are shaped the way it

is because : 1.) Expectations of rising short-term interest rate creates a positive yield curve. 2.) The

“liquidity preference hypothesis” states that investors always prefers higher liquidity of short-term

debt and so any deviation from positive yield curve will only be a temporary phenomenon. 3.) The

"segmented market hypothesis" states that different investors confine themselves to certain maturity

segments, making the yield curve a reflection of prevailing investment policies.

The yield curve takes three primary shapes , if short-terms yields are lower than long-term

yields, then the curve is referred to as positive, if the sort-term is higher than long term yield the

curve is referred as negative or inverted one. And if there is marginal or no difference between short

and long term yield, the curve will be flat.

Reference:

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