# A Query on Interest Rates

A short post today...

While I was going around a few sites, working with the financial tools they had to offer, I had a query on differences on interest rates (Read “Understanding interest rates“) “ING DIRECT pays 1.35% interest on savings. So it means that for every \$100 saved, I get \$1.35 which has a much greater purchasing power than 4% of interest that we get which amounts to INR 4 for every INR 100. Why is it so? Why do we get such a poor deal when it comes to interests? It’s like \$1.35 can get you an e-book for that matter, and INR 4 will literally get you peanuts or just pay half the price of a public bus ticket in Calcutta.

Here’s the explanation team-member, Mikky offered. You can read on if you ever had a similar doubt.

Interest is nothing but value of money.  It simply reflects the purchasing power your country’s currency has.

This concept also deals with something called convertibility INR creates far lesser force in the market than your dollar. But eventually, \$100 is INR 6000, and 1% interest is INR 60.

Because the convertibility of the dollar is high and it’s more fluidic in the market. Since, a dollar can be used to make more money, the bank is willing to give more. A rupee can’t. So our banks can’t pay as much. And this is all shown by your exchange rate. Read “What are Exchange Rates?

1. Interest is just what the bank offers to pay you in return for using your money and the rate, in theory, is calibrated to how much money the bank has and how much demand for loans there is. So if the demand is high then the bank will charge greater interest on its loans which it will pass on to its savers. If demand drops then the bank will cut its rates to try and boost demand and the interest rate that savers get will also be cut.

In practice though, central banks are printing so much money that it always outstrips the demand for loans and so interest rates are kept low. So when the Federal reserve says that they’re planning to keep interest rates at 1% what they’re saying is that they plan to print enough money to make loaning money so unprofitable that banks can only take 1% profit.

Purchasing power is just a ratio between how much a country produces and how many units of currency there are because money is meant to represent the total value of all manufactured goods. So if a central bank prints more money then each unit of currency, each dollar, each pound, each euro is worth a smaller and smaller fraction of the total value of manufactured goods. This we call inflation.

If you’re making 1.35% interest every year and the rate of inflation is 2% you’re actually losing purchasing power. Sure you have more dollars but each dollar is worth less.

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1. A. M. says:

Wonderfully explained 🙂

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