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Interest Rates and Demand for Money

Info: 1011 words (4 pages) Example Literature Review
Published: 6th Dec 2019

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Tagged: Banking

Banks play vital role in the economic growth and development of the country. So, to uphold the economic growth of the country, the banking sector must perform its task properly. For the banking sector, interest rates play the vital role as it has ability to affect total demand of money and subsequently, the investment opportunities.

Today interest rate spread is one of the frequently talked topics around the world because of its effect economic growth and investment opportunities. Interest rate spread is the extremely high difference between the asset that the banks earns and pays on its liabilities. Banks are one of the determining factors in interest rate spread. Market, along with commercial and the state bank, plays a significant part for the interest rate spread determination.

(Prithvi Man Shrestha, 2011) reported that the banking sector in Nepal is facing with the danger of liquidity crisis, inflated interest rate, declining deposits and danger of real estate collapse. Since the second half of the fiscal year 2009-10, the problem of the liquidity started which has affected the inter banking lending rate. In spite of higher interest rate provided by commercial bank in the deposits, it still fails to attract the depositors. Nepal Rastra Bank has mentioned that the deposits from commercial banks is diverted into class B and C financial institutions which has cause decrease in deposits in commercial banks.

Beside decline in deposits, another problem that banking sector were facing is to recover the loans given or provided to the realty sectors. Decrease in transactions of realty sector is seen since Nepal Rastra Bank stopped bank loans for the realty second in the second half of the fiscal year 2009-10. Nepal Rastra Bank limited the lending for the housing sector to 25 percent that of realty sector to 10 percent through economic plan.

On the other hand, bank is also facing problem to keep up profitability. The profit of banks has come down due to narrowing margin and extreme rivalry among BFI. Bankers are in disagreement that the recent procedures on service charge have forced them to keep two percent difference in the interest rates i.e. bankers are forced to intensify interest on normal deposits and subsequently increase interest on loans.

Interest rates are associated with the dealings of market needs and supplies to be precise money that is borrowed and lent. The money is borrowed for the desires of businesses purposes, financial expenses for the development purposes by the government and expenses for household activities. The money available in the bank to let the loan depends upon the amount that comes into banks and other financial sectors through means of comsumers and into financial markets. So, the dealings between the need of money to be borrowed and the availability of money to supply determines the level of interest rates. If any of these factors get affected, then this will cause direct impact on interest rates.

There are two risks associated with high interest spreads. It is also very important to know that, the impact of high spread interest rate on the economic growth both for commercial as well as central bank, because interest rate spread can be controlled by either of these two. One of the risks is that it may result in scarcity of money which ultimately leads to decrease in borrowing of money from the banks by consumer for household spending, construction by real estate, and investment on business which causes a recession.

Other risks that is associated with high interest rate spread is that some groups and business sectors on the business environment may suffer from an unequal proportion of higher interest rates and lack of credits impacts. As an example, small businesses which operate with relatively small profit margins are most likely to be affected. Small businesses get their profit cut so heavily so that they cannot afford to borrow money because of increment in the cost of borrowing money. This ultimately results in discouraging the small investor’s unwillingness to borrow the money from the bank and that makes small and medium businesses hard to survive in the business world. High interest spreads also encourage commercial banks to lend money to large, traditional borrowers but completely omitting capability of small and medium businesses and destabilized all the efforts to encourage slim down of loans to smaller borrowers.

Economic Production produced by a country in a given year is that country’s gross domestic product or GDP. The economic production includes all goods produced and services. To estimate the GDP, evaluation is done by considering values of goods and services using the price from the previous year. To study the effects of increased GDP is same as of studying effect of economic growth in interest rate.

According to Steven M. Suranovic, “The effect of real GDP on interest rate is essentially equivalent to the domestic economic growth on interest rate.” That means as GDP increases demand for fund increases and so aid in increasing interest rate.

As GDP increases so does the interest rate. These two economic components are directly interrelated to each other. For example: An economic progress results to number of investor investing which result in increased amount of load and to meet up lender ask for the higher rate of return.

GDP remarkably aid in increasing inflation and sometime the inflation might outpace GDP generating the negative impact of national economy. So, to control the inflation government pose higher interest rate to loans. This interest rate acts as a break to control investors on new investment.

But on the other hand, increased interest rate can depress investors for starting new and essential projects and might decrease GDP causing damage to the economy of the country. As said GDP and interest rate is inter-related. Changes in any one of them would have impact upon each other.

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Banking can be defined as the business of a bank or someone employed in the banking industry. Used in a non-business sense, banking generally means carrying out activities related to the management of one’s bank accounts or finances.

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