An interest rate is the rate at which interest is paid by borrowers for the use of money that they borrow from a lender. Specifically, the interest rate (I/m) is a percent of principal (P) paid a certain amount of times (m) per period (usually quoted per annum). For example, a small company borrows capital from a bank to buy new assets for its business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest rates are normally expressed as a percentage of the principal for a period of one year.
Interest-rate targets are a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment. The central banks of countries gelly tend to reduce interest rates when they wish to increase investment and consumption in the country’s economy. However, a low interest rate as a macro-economic policy can be risky and may lead to the creation of an economic bubble, in which large amounts of investments are poured into the real-estate market and stock market. This happened in Japan in the late 1980s and early 1990s, resulting in the large unpaid debts to the Japanese banks and the bankruptcy of these banks and causing stagflation in the Japanese economy (Japan being the world’s second largest economy at the time), with exports becoming the last pillar for the growth of the Japanese economy throughout the rest of 1990s and early 2000s. The same scenario resulted from the United States’ lowering of interest rate since late 1990s to the present (see 2007–2012 global financial crisis) substantially by the decision of the Federal Reserve System. Under Margaret Thatcher, the United Kingdom’s economy maintained stable growth by not allowing the Bank of England to reduce interest rates. In developed economies, interest-rate adjustments are thus made to keep inflation within a target range for the health of economic activities or cap the interest rate concurrently with economic growth to safeguard economic momentum.
Interest rate notations
What is commonly referred to as the interest rate in the media is generally the rate offered on overnight deposits by the Central Bank or other authority, annualized
The total interest on a loan or investment depends on the timescale the interest is calculated on, because interest paid may be compounded.
In retail finance, the annual percentage rate and effective annual rate concepts have been introduced to help consumers easily compare different products with different payment structures.
In business and investment finance, the effective interest rate is often derived from the yield, a composite measure which takes into account all payments of interest and capital from the investment. The notion of annual effective discount rate, often called simply the discount rate, is also used in finance, as an alternative measure to the effective annual rate which is more useful or standard in some contexts. A positive annual effective discount rate is always a lower number than the interest rate it represents.
Interest rates in the United States
In the United States, authority for interest rate decisions is divided between the Board of Governors of the Federal Reserve (Board) and the Federal Open Market Committee (FOMC). The Board decides on changes in discount rates after recommendations submitted by one or more of the regional Federal Reserve Banks. The FOMC decides on open market operations, including the desired levels of central bank money or the desired federal funds market rate. Currently, interest rates in the United States are at or near historical lows.
Reasons for interest rate changes
- Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on interest rates.
- Deferred consumption: When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.
- Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.
- Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.
- Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, die, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
- Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time to realize.
- Taxes: Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.
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