Interest rate

Also called: Rate of interest · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 10, Ch 3 "Money and Credit"; Class 11, Ch 6 "Correlation"; Class 12, Ch 1 "Introduction (Macroeconomics)"; Class 12, Ch 3 "Money and Banking"; Class 12, Ch 4 "Determination of Income and Employment"

Meaning

The interest rate (also called the rate of interest) is the price paid for using money for a period. It is written as a percentage of the amount per year.

• For a borrower, it is the cost of borrowed funds.
• For a person holding cash, it is the opportunity cost of holding money (the interest you give up by keeping cash instead of putting it in a fixed deposit or a bond).

It matters because one rate moves two big decisions. It decides how much money people want to hold, and how much firms borrow to invest. That is why it is the main tool of the RBI's monetary policy.

Key formulas:

• Real rate ≈ nominal rate − expected inflation (Fisher approximation)
• Total money demand: Md = kPY + (rₘₐₓ − r)/(r − rₘᵢₙ)

Explanation

Two jobs of the interest rate

• Job 1: the "price" of holding money.
• Liquidity means how easily an asset can be turned into goods. Money is the most liquid asset. You can spend it at once, at full value.
• Cash earns nothing. A fixed deposit or a bond earns interest. So keeping cash has a cost.

• Example: you keep ₹10,000 as cash for a year instead of putting it in a 7% FD. You lose ₹700 in interest.

• Job 2: the cost of borrowing.

• A higher rate makes loans for machines, factories and houses more expensive.

• The same rise in r works through both jobs:

• Higher r → holding cash costs more → people hold less money (money demand falls).
• Higher r → loans cost more → firms borrow less → investment falls.

Interest rate and the demand for money (Keynes)

• Demand for money (liquidity preference) is the part of wealth people choose to keep as money rather than as bonds. It is a trade-off: the ease of using cash against the interest you lose.
• Transaction motive: people hold money because income comes at fixed times (for example, a monthly salary) but spending goes on every day.
• Mᵀd = kPY. Here k = the share of transactions held as money (0 < k < 1), P = price level, Y = real income.
• This part depends on income and prices, not on r.
• Velocity v = 1/k. NCERT's two-person example: ₹200 of transactions need only ₹100 of money, so k = ½ and v = 2.

• Worked example: P = 2, Y = 500, k = 0.25. Nominal GDP = ₹1,000, so Mᵀd = ₹250. If P doubles to 4, Mᵀd doubles to ₹500.

• Speculative motive: people hold money instead of bonds to avoid a capital loss (a fall in the market price of an asset you own).

• Bond prices move opposite to interest rates. A bond pays a fixed coupon (yearly interest on its face value). When market rates rise, old bonds with fixed coupons look less attractive, so their price falls.
• NCERT example: a 2-year bond with face value ₹100 and a 10% coupon.
  • Price = C/(1+r) + (C+F)/(1+r)²
  • At r = 5% → ≈ ₹109.29. At r = 6% → ≈ ₹107.33.
  • A 1 percentage point rise in r means a loss of about ₹1.96 per bond.
• When r is high, people expect it to fall, which means bond prices will rise → they buy bonds and hold little money.
• When r is low, people expect it to rise, which means bond prices will fall → they sell bonds and hold money.
• Msd = (rₘₐₓ − r)/(r − rₘᵢₙ). It is zero at rₘₐₓ and infinite at rₘᵢₙ.

r (with rₘₐₓ = 10%, rₘᵢₙ = 2%)	Msd
10%	0
6%	1
4%	3
2.5%	15
→ 2%	→ ∞

• Result: money demand falls as r rises (a downward-sloping curve). It rises with income.

How the interest rate is set: money-market equilibrium

• The equilibrium r is where money demand Md(Y, r) = money supply Ms. Money supply is set by the RBI and the banks. On the diagram it is a vertical line.
• What makes r fall: more money supply (NCERT Box 3.1).
• The RBI raises the money supply → people hold more money than they want.
• They use the extra money to buy bonds → bond prices rise.

• r falls until people are happy to hold the larger money stock.

• What makes r rise: higher income.

• Higher Y → more money needed for transactions.

• With the same money supply, r must rise to bring demand back down to supply.

• Liquidity trap: at a very low rate (rₘᵢₙ), everyone expects r to rise, so bonds look risky.

• People simply hold any extra money. The bond-buying step stops working, so r cannot fall further.
• Money demand is infinitely elastic here (the Md curve is flat).
• Near the zero lower bound (rates close to 0%), central banks use other tools: quantitative easing, forward guidance and long-term lending operations. Examples are Japan from the 1990s, and the US, UK and eurozone after 2008 and in 2020.

Nominal vs real interest rate

• Nominal rate is the rate written on the loan or deposit.
• Real rate is the gain in actual buying power after inflation. Real ≈ nominal − expected inflation.
• Worked example: a repo rate of 5.25% against core inflation of 4.3% gives a real rate of about 0.95% [2].
• Why it matters:
• Savers and borrowers act on the real rate.
• A positive real rate holds back demand. A negative real rate pushes demand up.
• The real rate is compared with the neutral rate (the rate that neither speeds up nor slows down the economy).

In India

• Who manages it: the RBI, through its Monetary Policy Committee (MPC). The MPC sets the repo rate (the rate at which the RBI lends to banks for a short time against government securities).
• The legal anchor:
• The Monetary Policy Framework Agreement between the Government and the RBI was signed in February 2015. It adopted flexible inflation targeting (FIT) [4].
• Under Section 45ZA of the RBI Act, 1934, the Centre sets the CPI inflation target with the RBI once every five years [6][7].
• The first target, notified on 5 August 2016, was 4% CPI inflation, with an upper limit of 6% and a lower limit of 2% [6].

• The RBI released a Discussion Paper on Review of the Monetary Policy Framework on 21 August 2025 [8].

• The LAF corridor: the Liquidity Adjustment Facility (LAF) is how the RBI adds money to the banking system or takes it out [4].

• Floor = Standing Deposit Facility (SDF), where banks park surplus money with the RBI and need no collateral. It is 25 basis points below the repo rate [4].
• Ceiling = Marginal Standing Facility (MSF), where banks borrow overnight from the RBI in an emergency. It is 25 basis points above the repo rate [4].
• The SDF replaced the fixed reverse repo rate as the floor in April 2022 [4][5].

• The operating target is the Weighted Average Call Rate (WACR), the average rate on overnight loans between banks [4].

• How a rate change reaches you:

• The RBI adds liquidity (for example, a repo auction) → banks have more cash to lend overnight.
• The WACR falls towards the repo rate → bond yields and bank loan rates follow.

• When the RBI takes liquidity out (money moves into the SDF), the WACR rises within the corridor.

• Latest figures (August 2026 MPC): repo rate 5.25%, SDF 5.00%, MSF and Bank Rate 5.50% [2]. The MPC voted unanimously to keep the repo rate unchanged in June 2026 and August 2026 [2][3]. The stance is neutral (no bias towards cutting or raising rates) [2].

• Outlook: the RBI projects core inflation at 4.3% for 2026-27. It expects growth to stay resilient but slow down, with risks from the monsoon, El Niño, geopolitics and global trade policy [2].

Don't confuse with

• Nominal vs real interest rate: the nominal rate is the figure on the contract. The real rate removes inflation. Savers and borrowers decide based on the real rate.
• Bond price vs interest rate (yield): they move in opposite directions. The coupon on an old bond stays fixed, so when market rates rise, its price falls.
• Repo rate vs WACR: the repo rate is the policy rate the MPC announces. The WACR is the operating target, the market rate the RBI actually steers towards the repo rate through LAF operations [4].
• SDF vs reverse repo: both absorb banks' surplus money. The SDF needs no collateral. The reverse repo needs government securities. Since April 2022, the SDF (not the reverse repo) is the floor of the corridor [4][5].

Prelims Hooks

• The interest rate is the opportunity cost of holding money. So money demand is inversely related to r and directly related to income.
• Speculative demand: Msd = (rₘₐₓ − r)/(r − rₘᵢₙ). It is zero at rₘₐₓ and infinite at rₘᵢₙ. Transaction demand (kPY) does not depend on r.
• Liquidity trap: money demand is perfectly (infinitely) elastic at a very low rate, so more money supply cannot lower r.
• Corridor: floor = SDF (repo − 25 bps), ceiling = MSF (repo + 25 bps). The operating target is the WACR, not the repo rate [4].
• August 2026: repo 5.25%, SDF 5.00%, MSF = Bank Rate = 5.50%, neutral stance [2].
• Trap: the MSF is a borrowing window for banks, not a deposit window. The inflation target is fixed by the Centre (with the RBI) under Section 45ZA, every 5 years, at 4% ± 2% [6][7].

Mains Points

• The interest-rate channel depends on liquidity. The RBI announces the repo rate, but the WACR moves only through LAF operations. When there is too much or too little liquidity, the WACR drifts away from the repo rate. Then transmission (how fast bank loan rates follow the policy rate) gets weaker. So managing liquidity matters as much as the rate decision [4].
• Real rate and the growth vs inflation trade-off. A real repo rate near 1% (5.25% repo against 4.3% core inflation, 2026-27) raises a question [2]:
• Is it too tight at a time when the RBI expects growth to slow?
• Or is it needed to keep inflation expectations steady against monsoon and El Niño risks [2]?

• Link the answer to the FIT mandate of 4% ± 2% [6].

• Limits of monetary policy and changing money demand. The liquidity trap shows that at very low rates, extra money is held, not spent. That is why advanced economies used QE after 2008 and 2020, and why fiscal policy carries more weight in deep slumps. With the repo at 5.25% (2026) [2], this is not a present risk for India. Separately, UPI and digital payments lower k and raise velocity. This makes money demand harder to predict, which is one reason India moved from monetary targeting to an interest-rate operating target under FIT [4].

Related concepts

• Liquidity
• Opportunity cost of holding money
• Demand for money
• Transaction motive
• Speculative motive
• Velocity of circulation
• Liquidity trap

Read more

• Demand for money and the interest rate