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Interest is the price that a borrower pays for being able to realise his plans now, even though he does not have enough money saved up for this. Interest compensates the saver for giving up the use of his money for a certain time. Savings come primarily from private households. Demand for loans, on the other hand, comes mainly from businesses, which use the funds to finance their investment.
But what determines the level of lending and savings rates? Interest rates are a function of supply and demand, just like other prices. If money is in short supply and in demand, it becomes more expensive, i.e. the rate of interest rises. When money is plentiful, it becomes cheaper, i.e. interest rates fall. The lower the rate of interest, the greater the readiness to borrow money and to spend it on investments, such as buying new machinery. However, when interest rates are low, there is less incentive to save, and people will prefer to spend their money instead. Banks have to pitch their interest rates at the right level to ensure that the inflow of money from savers and the demand for loans are more or less in equilibrium. The banks play a key role when it comes to setting lending and savings rates.
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