The ups and downs of interest rates

A few weeks ago, Bloomberg announced that “Draghi unveils historic measures against deflation threat” and shortly thereafter there were headlines in all respectable news outlets announcing a decrease in interest rates. Did you wonder why that was newsworthy in the midst of your summer holiday preparation?

The news refers to Mario Draghi, the President of the European Central Bank (ECB). He’s not a Hollywood star nor a football player, and yet he makes the headlines almost as much as they do.

The price of money

People and companies are prepared to lend their money to others for a certain amount of time; in return, they ask to be remunerated for the costs that this entails: not being able to use that money during that period and the risk of failure to repay. The only scenario where people lend each other money without expecting to receive more in the end is in the case of very good friends. And of course parents lending to their children. In these situations, the benefit is social, not financial.

The difference between the initial amount borrowed and the amount paid back expressed in an annual percentage is called interest rate. So if you borrow EUR 1,000 and have to pay back EUR 1,030 after one year, the interest rate is 3%.
The percentage or rate will be larger the longer the period is and the less confident we are of being paid back.

And the same is true for banks when they borrow from each other and when they borrow from the ECB.

A European interest rate that affects all of us

The ECB lends money to banks at the official interest rate. This is one way for banks to get financing to do their business: they borrow from the ECB and lend it to other banks, to companies, and to you and me. When banks lend money to their clients, they charge an interest rate and a commercial margin based on the same idea we mentioned earlier: the cost of not being able to use the money otherwise and the risk of repayment. The mean of all these interest rates gives the Euribor rate, which we will discuss in another article.

Therefore, when the ECB lowers the interest rate at which it lends to banks, implicitly it is lowering the Euribor rate which directly or indirectly affects the price of lending for all of us.

And the effect of this? If borrowing money is cheaper, companies and individuals will borrow money to invest (from big factories to a new moped) driving prices upward, i.e. increasing inflation levels. A lower interest rate means also that savings deposits pay less, so again companies and individuals will rather invest the money in, for example, shares than park it with the bank. All of this spurs on economic activity, and that’s a good thing in times of crisis!

So next time Draghi speaks, you might want to pay attention: it could help you decide whether to go on a luxury vacation or just visit some family…

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