An interest rate is the monthly rate you pay as a borrower, or receive as a creditor/lender. If you save money in bank, or invest in a money market, you are indirectly lending money to a borrowing corporation (or the government). If the interest rate goes up, the borrower must pay you more, which makes them unhappy but you happy (your bank balance soars). The mood swings the other way when interest rate goes down.

Here we are talking about a real interest rate, which is the rate after adjusting for inflation. So, for the purpose of this topic, just assume inflation does not exist (hard, I know, given the reality, but it simplifies our discussion).

Demand and supply influence the real interest rate

There are almost as many different types of interest rates as the investing and borrowing choices available to us (your bank pays you one rate, and you pay another rate to your credit card company). But they all respond to three fundamental market forces: supply of funds, demand for funds, and occasional government interventions.

Households supply funds via their invested assets, whereas corporations and the government borrow these funds to finance their needs (see this post on the interaction between investors and borrowers). This dynamics of supply and demand determine how all these different rates arise. It is easy to think in terms of a single abstract rate, as the picture below illustrates, which plots real interest rate against available fund.

The supply curve (solid blue graph) goes up from left to right, because with increasing interest rate the households save and invest more. By contrast, the demand curve (solid red graph) falls as more fund is available. The intersection of these two curves, point A, determines the equilibrium real interest rate.

Now suppose there is an increase in the budget deficit, which will raise the government’s borrowing demand. This pushes the demand curve to the right (dashed red graph), and lifts the interest rate to point B, which in turn may discourage businesses from further borrowing and slow the economy down. The government may then intervene by releasing more fund from the central bank (Federal Reserve). This action pushes the supply curve to right (dashed blue graph), and brings the interest rate down (to point C).

So, again, the fundamental market forces that set the interest rate, and run the investing world, are the demand and supply of funds.

You and I, as members of the household sector, want to invest our money, whereas the business sector wants to raise money to pay for real assets. Such supply and demand requirements create an atmosphere of synergistic interactions between these two sectors.

Financial intermediary – (1) Banks

The problem is that the size of a typical household investment is too small to meet the need of large businesses. I cannot lend Microsoft enough money to make a whiff of a difference to its finances. But, if funds are pooled together from a large number of households, businesses can then borrow from this substantial pool.

Thus, a financial intermediary can make a profit from the difference between the interest it charges the businesses (borrower) and the interest it pays the households (lender). This is exactly what a bank does. The mismatch of scales between the interests of household and business sectors allow banks to earn by providing a service that indirectly brings them together.

(2) Investment companies

Besides borrowing from banks, businesses also sell stocks and bonds directly to the investors. Here again, the smallness of household assets becomes a problem. An investor cannot often afford the substantial brokerage and trading costs to own a large number of securities from different companies (that is needed to adequately diversify his portfolio).

Investment companies, such as Vanguard, Fidelity and T. Rowe Price, have evolved from these mutual needs to sell and buy company securities. Like banks, they pull together funds from small investors and purchase a variety of securities. Each investor pays for shares of this composite holding, known as a mutual fund, which provides the necessary diversification. Part of the payment goes to the fund operators as management fees.

Investment banks

Unlike the banks and investment companies that serve as intermediaries between investors and businesses, investment banks provide services only to the businesses. Because firms issue stocks and bonds to raise funds, investment bankers such as Merrill Lynch, Goldman Sachs and Smith Barney advice them, for a fee, on the prices they should charge for these securities, prevailing market conditions, appropriate interest rates and so on. They also act as brokers in seeking out investors when new securities are issued.

It helps to know the main components of a financial world, the forces they exert and the interests they represent. There are three major players: household sector, business sector and government sector.

Household sector

This is the human component of an investing environment, people like you and me, the individual investors. We work and earn income in return for our services. We spend part of the income to meet our consumption needs, and invest the rest to support ourselves after retirement. Tax and risk aversion are the two major concerns that shape our investment choices and decisions.

Business sector

The household sector wants to invest the “excess” fund, whereas the business sector needs fund to finance their real assets (technology, wages for employees, and so on). They acquire funds by, (1) borrowing from the household (indirectly via banks, or directly by issuing corporate bonds), and, (2) forming “partnership” with investors (by issuing ownership stakes in terms of company stocks).

Government sector

The government also needs fund (to run itself, of course). But, unlike the business sector, they cannot invite partners by issuing a “government stock”. The government has a direct funding source by imposing tax on our income. They also own printing press, and can print currency if needed (raises inflation concern though). When tax revenue is not enough, the government borrows fund by issuing securities such as treasury bonds, notes and bills.

Demand-Supply chain

Thus, in a financial world, the household sector constitutes the supply end of the money chain, whereas the business and government sectors make the demand end of it. The other half of the chain that completes the full circle, where households get their money (from the other two sectors) as income for services rendered, lies outside of the investing environment.