The equilibrium rate of interest is the interest rate at which a balance is achieved between money supply and loan demand in a market. This rate will usually be established by a money market through the regular trading of interest-bearing securities like bonds. There are certain occasions when a government may decide to adjust the equilibrium rate of interest to either stimulate spending or selling. All markets are affected to some extent by this rate, especially bonds, which are often measured by the interest rate they offer when compared to the equilibrium rate.
Interest rates are a major factor in the financial status of an economy. They affect just about every financial transaction where a loan is involved, from credit cards to mortgages to personal loans. In addition, they play a major role on the bond market, which is formed by investors giving loans to institutions in return for interest payments and eventual return of the principal of the loans. The equilibrium rate of interest acts as the balancing point for all of these interest rates.
It is important to understand how interest rates work when considering the equilibrium rate of interest. Lenders will loan more money when interest rates are on the rise. On the other hand, borrowers are constantly in demand of lower interest rates. That point at which the two parties meet is the equilibrium rate, marking a perfect balance of supply and demand of funds to be loaned.
At times, a government may feel the need to balance out the economy and adjust interest rates. If they raise interest rates, bond investors will respond by buying more bonds. This in turn will eventually lead to higher prices for bonds, at which point the return on bond investments will also drop. When this occurs, investors will begin selling off bonds once again, resulting in interest rates dropping until they eventually stabilize. In this way, a new equilibrium rate of interest will be reached.
Investors often gauge the equilibrium rate of interest by the rate charged on a particularly stable security. For example, Treasury bonds issued by the United States government generally offer great stability and little risk to investors. The rate attached to Treasury bonds can be considered a good approximation of the equilibrium rate, and investors can also use it to measure the rates of other fixed income instruments. Bonds with rates in excess of the equilibrium rate may be profitable, but investors must understand that the potentially higher returns come with higher risk levels attached.