When the economy is overheating or operating above the country’s normal capacity to produce, inflation will follow.
So the interest rate is going up now.
What is interest rate?
Very simply, it is the price we pay for borrowing money from another entity or what we charge to anyone who borrows from us.
Individually, we borrow to meet our needs such as to pay for our medical bills, build a house, get a new car, or for any purpose.
Business also borrows generally to make new investments or cover some of its working capital needs such as to buy raw materials, for example.
When we borrow, say P100,000 for a year from a bank, it may charge us 12 percent per annum.
This means that after one year, we return the P100,000, plus the P12,000 in interest to the money we borrowed.
We may borrow to start a business which we think might give us 20 percent profit in a year after expenses, thus giving us 8 percent net profit after paying the 12 percent interest rate.
If the bank increases the rate to 16 percent, we may find that our profit is now down to 4 percent.
Shall we continue our business?
Not if we find the 4 percent net profit no longer worth our effort.
The higher is the interest rate, the less profitable business would be.
This discourages investments in the economy.
Any investment made increases the productive capacity of the nation.
More investments means more capital per worker.
More capital per worker also means more output or gross domestic product (GDP) per worker.
With higher output comes higher per capita income which increases the welfare of every one of us, assuming there is inclusiveness or broader participation in the way our GDP is produced and distributed.
That is what interest rates meant to us individually and the nation as a whole.
There are many types of lending and borrowing.
Some are collateralized, some are not.
Some are short term, some are long term.
Different types of loans differ in interest rates.
It also differs based on the borrower’s capacity to pay and track record.
Thus, there is such thing as prime rates, the lowest rate charge to those borrowers with unquestionable capacity to pay and track record.
Those with little capacity and unknown or questionable track record will be charged higher rates.
The BSP also lends and borrows money.
This it does to influence the overall level of economic activity in the country.
When the economy is slowing down or in a recession, the BSP will inject more money into the economy by lending to banks, its main clients.
This also enables banks to lend more to investors.
To inject more money into the economy, the BSP usually lowers its lending rates.
This also allows banks to lend more at lower rates to investors, thus expanding the economy in the process.
We can see that bank’s lending rates also depends on BSP’s lending rates.
When the economy is overheating or operating above the normal capacity of the country to produce, inflation will follow.
When this happens, the BSP will reverse what it does during a recession or slowdown of the economy.
It will raise the interest rates and withdraw money from the banking system.
This cools down the economy and lowers inflation.
I wish I had more space here but suffice it to say that what the BSP does is called monetary policy which could be easy or tight depending on the direction in which it moves the level of money supply and interest rates.
This is different from fiscal policy which I will discuss here next week.