An interest rate is the price a borrower pays for the use of money they borrow from a lender,
for instance a small company might borrow capital from a bank to buy new assets for their business,
and the return a lender receives for deferring the use of funds, by lending it to the borrower.
Interests rates are fundamental to a Capitalist society and are normally expressed as a percentage rate over the period of one Gregorian year.
Interest rates targets are also a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment.
Reasons for interest rate change
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.
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.
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, 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.
People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize.
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.
Output and unemployment
Interest rates are the main determinant of investment on a macroeconomic scale. Broadly speaking, if interest rates increase across the board, then investment decreases, causing a fall in national income.A government institution, usually a central bank, can lend money to financial institutions to influence their interest rates as the main tool of monetary policy. Usually central bank interest rates are lower than commercial interest rates since banks borrow money from the central bank then lend the money at a higher rate to generate most of their profit.By altering interest rates, the government institution is able to affect the interest rates faced by everyone who wants to borrow money for economic investment. Investment can change rapidly in response to changes in interest rates and the total output.
Money and inflation
Loans, bonds, and shares have some of the characteristics of money and are included in the broad money supply.By setting it, the government institution can affect the markets to alter the total of loans, bonds and shares issued. Generally speaking, a higher real interest rate reduces the broad money supply. Through the quantity theory of money, increases in the money supply lead to inflation.