Explain the factors influencing interest rates in the economy.

Explain the factors influencing interest rates in the economy.

CSS Solved Business Administration Past Papers | Explain the factors influencing interest rates in the economy.

The following question is attempted by Miss Nimra Masood, the top scorer in CSS Business Administration papers. Moreover, the answer is written on the same pattern, taught by Sir to his students, scoring the highest marks in compulsory subjects for years. This solved past paper question is uploaded to help aspirants understand how to crack a topic or question, how to write relevantly, what coherence is, and how to include and connect ideas, opinions, and suggestions to score the maximum.

Topic Breakdown:
Interest rate is an indicator of the economic condition of any country. Calculating interest rate is a technical task as there are many factors that influence its intrinsic value. From the country’s internal economic conditions to global economic environment, all influence the interest rate.
Topic: Valuation
Subject: Finance


“Amount of Interest due Per Year”


“Interest Rate is a measure of the compensation that lender receives from borrowers in exchange for a loan”.

Elements of interest rate:

  • Default risk premium:
    It is the risk that a borrower will default on a loan which means not pay the interest of the Principal. Higher the default risk the higher with be the interest rate. It also depends on the creditworthiness of the person or entity involved.
  • Liquidity premium:
    Some investments are highly liquid, meaning they are easily exchanged for cash. Other securities are less liquid, and they are traded less frequently. Holding other factors equal, less liquid security must compensate the holder by offering a higher interest rate
  • Market Maturity Premium:
    All else being equal, a bond obligation will be more sensitive to interest rate fluctuations the longer to its maturity. It is charged by the investor for capital losses due to changes in the market interest rate.
  • Inflation:
    One critical factor that affects the interest rate is inflation. It is the steady rise in prices of commodities over a period of time. It is measured by comparing and tracking a basket of goods and services. The higher the prices or inflation the lower will be the purchasing power of consumers. Inflation also affects the government’s ability to borrow or subsidize commodities.
  • Risk-free Rate:
    One last element is the risk-free rate. It is the rate that would be charged in an ideal scenario where there is no risk and inflation does not exist.

Other factors that influence interest rates in the economy:

  • Demand for money:

The flow of money is one factor that significantly influences the prevailing interest rate. The demand or need for money is particularly higher when the economy is growing at a steady pace. Investors are willing to invest money in businesses, while there are a considerable number of borrowers in the market. Therefore, the demand for money higher will be the interest rate. This is a rule of thumb that when a commodity or money is in demand, lenders or sellers tend to charge a higher amount for that thing. Thus, the more the demand for money more will be the leverage with lenders to charge higher interest rates. On the contrary, the lower the demand for money, the lower will be the interest rate.

  • Supply of money:

Another factor that affects the supply of money is the supply of money. The more the supply of money lower will be interest rates, and vice versa. When the economy tends to slow down, investors are reluctant to invest money in businesses. Instead, they deposit their savings in return for a profit. Similarly, as banks are flooded with money, they are unable to lend it all; therefore, they decide to invest in government bonds and treasury, ultimately resulting in a fall in yield on the bond. Likewise, the decision of borrowers to defer payments and alike can cause a shortage of money supply, hence, leading to a higher interest rate.

  • Fiscal deficit and government borrowing:

A fiscal deficit is the shortfall between revenue and expenditure of the government. The more the expenditure, the more will be the fiscal deficit; hence, the government resorts to borrowing from the market. Consequently, the demand for money increases resulting in the rise of interest rates. A country like Pakistan, which relies heavily on borrowing to meet its fiscal deficit, experiences a considerably high-interest rate. The recent 3% rise in interest rate is an evident example of how money flow influences the interest rate.

  • Global interest and foreign exchange rate:

In this globalized world, no economy can survive on its own, the global economy and interest rates influence the local markets. The fluctuations in global interest rates do have an influence on the local interest rate to attract foreign investment. Similarly, the foreign exchange market and activity also have their say in interest rates. A higher flow of foreign capital means there is an additional supply of money, hence, the lower interest rate. Depreciation in the exchange rate will cause inflationary pressures. This is because imports become more expensive, and there will be greater demand for exports.

  • Central Bank:

Finally, the government’s decisions on the state of the economy and monetary policy influence the interest rate considerably in the short run. When the economy is going through a growth period, the government may decide to control inflation and increase the interest rate to curtail investment and consumption both. On the contrary, in recession times, the government may lower interest rates to increase the flow of money and encourage people to invest in the market.


The interest rate varies across economies depending on their economic conditions and other relevant factors. Although most people think of interest rates to be speculative, in reality, there is a mechanism that derives the interest rate amount. The economic conditions, inflation and the global economy all contribute to the calculation of real interest rates. Furthermore, there are also some risks associated with the interest rate, like default and liquidity risk. An economy like Pakistan, on the brink of default, has considerably higher default risk, thus, higher interest rates. On the contrary, stable economies like China and Japan have very low-interest rates due to almost negligible inflation and consistent economic indicators.

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