The interest rates at which financial institutions like banks lend money to borrowers depends on the cost at which banks can obtain the funds that are being lent.
A bank has funds deposited in accounts that are created by its customers for which the bank has to pay the depositors an interest. Banks also cannot lend all the money that they receive as deposits and have to keep a portion of the funds in the form of risk-free and highly liquid financial instruments like government bonds. The percentage of funds that have to be kept in this form is fixed by the Central Bank; this is done to ensure that banks always have sufficient funds to repay those that have deposited funds. To manage liquidity on a daily basis banks can either borrow funds from other banks or from the Central Bank for which they have to pay some amount as interest. The rate at which funds can be borrowed from the Central Bank is also fixed by it.
If banks have to maintain a larger portion in the form of government securities and are allowed to lend a smaller amount or the interest rate at which they can borrow funds is increased it becomes essential for banks to increase the interest rate on loans to remain profitable.
A higher interest rate on loans decreases the demand for loans by borrowers and a decrease in the interest rate increases the demand for loans.
Interest rates are one of the main ways to influence a the countries main activities.
For eg :- If a country is experiencing high inflation then the central bank would increase the interest rates of a country so that now people are encouraged to save more rather than spending.
Another example would be if country is experiencing unemployment then a country would reduce the interest rates so that people would spend more on goods and services therefore employment increased as people are employed to produce goods and services due to an increase in aggregate demand.
Another example would be if a country is experiencing a Balance of payment deficit the country would increase interest rates so that ii would attract hot money flows therefore more funds are bought to the country.
The central bank always makes changes to the interest rates of the country in order to influence the economic activities in a country.
This also known as monetary policy