Economics Explained: What are interest rates and what is their effect in the eurozone

An interest rate is the price of money. If you lend money to someone, you need to be compensated for not having access to that amount for a period of time.

Interesting to know
Interest rates influence how much people decide to spend and how much they save – but why is that?

Let’s take the example of rising interest rates. When interest rates rise, consumers are motivated to put more money into their savings account. This means lending money to the bank, which returns the interest rate as compensation. With higher interest rates, more savings in the bank yield a higher return.

On the other hand, lower interest rates induce people to save less and spend more.

One zone, mostly zero
Lately we have seen low interest rates of close to zero and even negative. Why is that? Low interest rates should discourage people from putting their money in the bank and instead encourage them to spend. More spending makes the economy move, as a higher demand for goods raises the profits of companies, which in turn hire more employees with greater spending power to buy more goods.

Low interest rates have been used as a tool by central banks to stimulate the economy after the financial crisis.

In Europe, the European Central Bank (ECB) sets interest rates for countries using the euro. Some 19 countries use the euro, spanning the continent from sunny Italy in the south, through hard-working Germany in the middle, to work-life-balanced Finland in the north, all linked by one currency and one interest rate.

The tools to succeed
So, can one interest rate setting have the same desired results described above in all 19 different states?

European countries are different on many levels. Setting a common low interest rate to stimulate spending in countries that had more difficulties during the crisis – like Spain, Italy and Greece – can overheat more stable and savings-loving economies like Germany. In Germany, people have been investing in housing to find an alternative return on their savings, and this has consequently driven up housing prices.

Nevertheless, this does not mean that the eurozone does not work. On the one hand, the ECB has other tools to tackle crises at a national level, like quantitative easing. And on the other, countries would not be better off outside a currency union since international markets are integrated to such an extent that it is difficult to set interest rates completely independently.