Few concepts in economics are so talked about and so often in the news, but at the same time so poorly understood, as interest rates.
Interest rates seem to involve lots of theory and more than a little guesswork about the economy, and even experts can't reliably predict what rates will do next. While all that may be true, nonexperts can gain a good basic understanding of interest rates by thinking about them in terms of supply and demand, specifically in the context of the Treasury bond market.
Simply put, interest rates represent the cost of borrowing money. When people talk about “interest rates,” they usually mean the general cost of borrowing money in the economy.
Interest in free market
Interest rates are important: low rates stimulate economic activity by making it cheaper for companies to expand and for people to buy houses and cars. Increased expansion and consumer demand result in more jobs. Higher rates discourage economic activity because they make such activity more costly.
Supply and demand refers to how prices are set in a free market. Prices are sensitive to supply and demand: when supply is greater than demand, the price typically moves lower. The opposite is true as well — if supply tightens, the price moves higher. For example, if the instability in Egypt were to spill over into its oil-producing neighbors and halt oil exports for a while (i.e., reducing supply), the price of oil would probably go higher in the U.S.
Supply and demand seem pretty straightforward as they apply to goods and services. It's just common sense that if everyone had the golden touch, like King Midas, the price of gold would probably go lower.
Interest rates, though, are intangible, and people don't buy and sell them in the ordinary way. They do, however, buy and sell assets that yield streams of earnings. The interest rate, or return on investment, is simply the ratio of annual earnings to the price of the asset.
So it's helpful to consider the Treasury market where, as in any market, supply and demand determine price and quantity sold. Understanding the relationship between a Treasury bond's price and the interest it pays is the key to understanding how supply and demand controls interest rates. A simplified primer on bonds is in order.
How bonds work
A bond pays a fixed amount of income each year, representing a fixed percentage of its face value: that percentage is its coupon, or stated interest rate. Assume that on day one of issue, that bond has a price of $100,000 and a coupon of 4 percent, meaning that the bond pays $4,000 per year in interest. If an excess of buyers pushes the price of the bond up to $125,000, then a new interest rate comes into play. This is called the current yield. The current yield is the percentage that, when multiplied times the new price ($125,000), equals the original yearly interest ($4,000). In this example, after the price increase the current yield is 3.2 percent (because 3.2 percent of $125,000 equals $4,000). So if the price of the bond goes higher, the yield goes lower in the same proportion. And if the yield goes higher, the price of the bond goes lower.