When a lender issues a loan, he generally charges a rate of interest on the loan. This interest rate is designed to provide the lender a profit, as he will receive more back from the borrower than he issued out. However, the lender will only make a profit if the money he receives back is able to buy more than when he loaned it out. Therefore, he must pay attention to the inflation rate.
In most healthy economies, money will slowly lose its value over time. When a unit of currency can buy less at moment of time than it could previously, it is said to have undergone inflation. However, in some cases, a unit of currency will gain value. This is called deflation. Although this may sound good, deflation can actually cause havoc in an economy, in part because of its effect on interest rates.
When deflation occurs or is expected to occur, lenders will generally dial back interest rates. This is because the value of the money that the lenders will receive when borrowers pay back their loans will likely be greater than the value of the money that the lenders issued. Therefore, to remain competitive, lenders will cut back interest rates, yet still make a profit on their loans.
Supply and Demand
When deflation occurs, people will often borrow less money. This is because deflation may cause salaries to drop, making it harder to pay off loans. This can lead to a drop in the demand for loans, forcing lenders to offer even lower rates to attract customers. This drop in demand for loans can lead to less economic expansion, which can further depress prices, leading to economic havoc.