Interest rates are a key component of the economic system. They are the price of money and serve as the standard for loans and deposits, marking the starting point for all financial transactions. When interest rates rise, consumption and investment are restrained, whereas lower rates result in increased liquidity and stimulate the economy.
Interest rates are the cost associated with borrowing funds over a specific period. Borrowers pay interest rates, while depositors receive them. On the surface, this is known as the interest rate, but in reality, the interest rates within an economy are determined by a range of factors including the supply and demand for funds, monetary policy, price levels, credit risk, and the duration structure.
The benchmark interest rate set by the central bank is at the core of the interest rate system. The base rate announced monthly by the Bank of Korea applies to short-term fund transactions between financial institutions, which directly impacts the deposit and loan rates at commercial banks. For example, if the benchmark interest rate increases, market loan rates also rise, escalating the interest burden on households and businesses.
The base rate reflects the direction of monetary policy. If inflation is a concern, the rate is increased to retract money in circulation, whereas during severe economic downturns, the rate is lowered to supply funds. During the 2008 global financial crisis and the 2020 COVID-19 pandemic, major countries reduced their benchmark interest rates to historically low levels. Conversely, since 2022, the U.S. Federal Reserve and the Bank of Korea have swiftly increased rates to control high inflation.
There are also various interest rates formed in the market, including government bond rates, corporate bond rates, deposit rates, and loan rates, all of which are determined based on market conditions, credit risk, supply, and demand. Generally, the lower the credit rating and the longer the maturity, the higher the interest rate. The difference between long-term and short-term rates is also used as an indicator of economic prospects. A phenomenon where long-term rates fall below short-term rates, known as an ‘inversion,’ is interpreted as a sign of economic recession.
Interest rates have a pervasive impact on the broader economy. For households, rising mortgage rates reduce purchasing power, and for businesses, increased capital procurement costs delay investment decisions. Even a country’s ability to issue government bonds and manage public finances are affected by interest rates. A period of rising rates escalates debt burdens and leads to direct adjustments in asset prices in financial markets, affecting stocks, real estate, and bonds.
Beyond deposits and loans, interest rates are also closely tied to foreign exchange markets. High interest rates attract foreign investment, stabilizing exchange rates, while low rates can trigger capital outflows and sharp increases in exchange rates. Interest rates play a crucial role in maintaining the value of domestic currency and the national credit rating.
Interest rates embody the “invisible hand.” They align with the policy direction of authorities and the market’s expectations to coordinate the rhythm of the economy. A single figure can alter the choices of numerous economic actors, acting as a bridge linking the financial and real economies. A precise understanding of interest rates is vital not only for asset management but also for reading economic trends.
