Four tier structure for rates of interest in any economy

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The starting point for any interest is the rate of inflation in the economy. Like for example, in India at present, it is around 3% now. We have seen earlier that interest is the compensation for loss of purchasing power of Indian Rupee. This loss is due to the phenomenon of “inflation”. We have also learnt that the banks would normally offer a rate of interest higher than the rate of inflation. Based on this, let us construct a 4-tier system of interest rates. This would build up stage-wise rates of interest till investment in a project.

Tier 1 – Rate of inflation, say 3%

Tier 2 – Rate of interest on investment say in bank deposit

Rate of inflation + some compensation from the acceptor of deposits, say banks. = 3% + 4% = 7%, that is the lowest interest offered by a public sector bank now on fixed deposits. The exact premium paid to the depositor depends on the following:

¨        The duration of the deposit – the longer the duration, the higher the premium and vice-versa. That is why the longer duration deposits would attract higher rates of interest and shorter duration deposits would have a lower rate of interest.

¨        The need for deposits by the banking company for a specific period. The bank would offer a higher rate for that period. Suppose a bank wants more deposits for six months rather than one year. It will attract deposits for six months by offering higher rate of interest than the market.

Tier 3 – What does the bank do with the deposits that it accepts? It gives loans. The rate of interest on loans becomes the next tier, Tier 3

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