Debt is a good thing. It might seem counterintuitive but debt allows people to own their own homes, businesses to grow and for all of us to live more happy, prosperous lives. Just as an example, a button maker who borrows £1,000 and uses it to buy a new machine which produces three times as many buttons will be able to pay back the £1,000 and make a healthy profit to boot. That's the theory anyway.
Why would you ever lend someone money? Not only are you depriving yourself the opportunity to spend that money but there's the risk you might never get it back. Interest rates are the way people who lend money get something back for the trouble. If A lends B £100 at a rate of 1% then he can expect to be paid back £101. That is he receives the £100 he originally lent plus £1 as his reward for having done so.
Banks operate by borrowing money from people at one interest rate and then lending that money to other people at a higher rate. In other words, if I put £200 in the bank then they might pay me a 1% interest rate but then lend that money to you at 2%. I receive a £2 reward for having deposited my money with the bank whilst the bank receives £4 from you in return for lending the money on to you.
If things were left like this the system would constantly seize up. Each time someone went to a bank to ask for a loan the bank would have to wait till someone else deposited an equal or greater amount in the bank with which it could make the loan. To stop this happening governments make continual short-term loans to banks to provide them with ready money to lend on to other people. They do so through central banks. In Britain this is the Bank of England, in America it's the Federal Reserve, whilst in the eurozone (those countries using the euro) it is the European Central Bank.
The interest rate at which governments make these loans is the most important interest rate there is. This is because the interest rates banks charge people borrowing money from them will always be higher than the rate at which banks borrow from the central bank. If the central bank's rate is low then banks will charge borrowers lower interest rates and vice versa. At the moment the Bank of England's rate is 0.5%.
Why do we have such a low interest rate? At the moment banks simply aren't lending anyone any money. The idea is that if banks can borrow money more cheaply from the Bank of England then they will be able to lend that money on to everyone else at an affordable rate. The fact that this still isn't happening shows the limits of what interest rates can do. Low interests rates alone won't get us out of the economic mess we're in now. They will help though.
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Most of the ideas here were stolen from those far more intelligent than myself, chiefly John Lanchester's "Whoops!"
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