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Encyclopedia > Interest rate

An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. Interest rates are normally expressed as a percentage over the period of one year. In finance, interest has three general definitions. ... In economics and business, the price is the assigned numerical monetary value of a good, service or asset. ... An example of Money. ... A percentage is a way of expressing a proportion, a ratio or a fraction as a whole number, by using 100 as the denominator. ...


Interest rates are also a vital tool of monetary policy and are used to control variables like investment, inflation, and unemployment. Monetary policy is the government or central bank process of managing money supply to achieve specific goals—such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth. ... Invest redirects here. ... An 1837 political cartoon about unemployment in the United States. ...

Contents


Causes of 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, 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 or money to realise.
  • 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.

In Keynesian economics consumption refers to personal consumption expenditure, i. ... Time preference is the economists assumption that a consumer will place a premium on enjoyment nearer in time over more remote enjoyment. ... The examples and perspective in this article or section may not represent a worldwide view. ... In finance, default occurs when a debtor has not met its legal obligations according to the debt contract, e. ... A risk premium is the minimum difference between the expected value of an uncertain bet that a person is willing to take and the certain value that he is indifferent to. ...

Real vs nominal interest rates

The nominal interest rate is the amount, in money terms, of interest payable.


For example, suppose a household deposits $100 with a bank for 1 year and they receive interest of $10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum. A nominal interest rate is a rate as stated. ...


The rl interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account. (See real vs. nominal in economics.) In economics, the distinction between nominal and real numbers is often made. ...


If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero. The real interest rate is the interest rate charged to a risk free borrower, minus the inflation rate. ...


After the fact, the 'realized' real interest rate, which has actually occurred, is:

ir = inp

where p = the actual inflation rate over the year.


The expected real returns on an investment, before it is made, are:

ir = inpe

where:

in = nominal interest rate
ir = real interest rate
pe = expected or projected inflation over the year.

Market interest rates

There is a market for investments which ultimately includes the money market, bond market, stock market and currency market as well as retail financial institutions like banks. A market is, as defined in economics, a social arrangement that allows buyers and sellers to discover information and carry out a voluntary exchange. ... For short-term mutual funds investing in money market securities, see Money fund The money market is the financial market for short-term borrowing and lending, typically up to thirteen months. ... The bond market refers to people and entities involved in buying and selling of bonds and the quantity and prices of those transactions over time. ... The examples and perspective in this article or section may not represent a worldwide view. ... The Currency Market or Foreign Exchange Market is one of the largest markets in the world. ... The First Provincial Bank of Taiwan in Taipei, Republic of China was formerly the central bank of Taiwan Province and issued the New Taiwan dollar. ...


Exactly how these markets function is a complex question. However, economists generally agree that the interest rates yielded by any investment take into account:

  • The risk-free cost of capital
  • Inflationary expectations
  • The level of risk in the investment
  • The costs of the transaction

Risk-free cost of capital

The risk-free cost of capital is the real interest on a risk-free loan. While no loan is ever entirely risk-free, bills issued by major nations like the United States are generally regarded as risk-free benchmarks. A £20 Ulster Bank banknote. ...


This rate incorporates the deferred consumption and alternative investments elements of interest.


Inflationary expectations

According to the theory of rational expectations, people form an expectation of what will happen to inflation in the future. They then ensure that they offer or ask a nominal interest rate that means they have the appropriate real interest rate on their investment. Rational expectations is a theory in economics originally proposed by John F. Muth (1961) and later developed by Robert E. Lucas Jr. ... The real interest rate is the interest rate charged to a risk free borrower, minus the inflation rate. ...


This is given by the formula:

in = ir + pe

where:

in = offered nominal interest rate
ir = desired real interest rate
pe = inflationary expectations

Risk

The level of risk in investments is taken into consideration. This is why very volatile investments like shares and junk bonds have higher returns than safer ones like government bonds. Risk is the potential impact (positive or negative) to an asset or some characteristic of value that may arise from some present process or from some future event. ... Volatile is the name of more than one concept: A financial instrument with high volatility is considered volatile in economics. ... Look up share on Wiktionary, the free dictionary. ... High yield debt (non-investment grade or junk bond) is a business term referring to a corporate debt instrument, usually a bond, that has a higher yield (compared to investment grade debt) because of a high perceived credit risk (default risk). ... A government bond is a bond issued by a national government denominated in the countrys own currency. ...


The extra interest charged on a risky investment is the risk premium. The required risk premium is dependent on the risk preferences of the lender. A risk premium is the minimum difference between the expected value of an uncertain bet that a person is willing to take and the certain value that he is indifferent to. ...


If an investment is 50% likely to go bankrupt, a risk-neutral lender will require their returns to double. So for an investment normally returning $100 they would require $200 back. A risk-averse lender would require more than $200 back and a risk-loving lender less than $200. Evidence suggests that most lenders are in fact risk-averse. In Economics, the term risk neutral is used to describe an individual who cares only about the expected outcome of an investment, and not the risk (variance of outcomes or the potential gains or losses). ... Risk aversion is a concept in economics and finance theory explaining the behaviour of consumers and investors under uncertainty. ... A risk lover is a person who has a preference for risk. ...


Generally speaking a longer-term investment carries a maturity risk premium, because long-term loans are exposed to more risk of default during their duration.


Liquidity preference

Most investors prefer their money to be in cash than in less fungible investments. Cash is on hand to be spent immediately if the need arises, but some investments require time or effort to transfer into spendable form. This is known as liquidity preference. A 10-year loan, for instance, is very illiquid compared to a 1-year loan. A 10-year US Treasury bond, however, is liquid because it can easily be sold on the market. Cash usually refers to money in the form of currency, such as bills or coins. ... Keynes developed the Liquidity Preference of Interest in The General Theory. ... Treasury Securities are bonds issued by the U.S. Treasury. ...


A market interest-rate model

A basic interest rate pricing model for an asset

in = ir + pe + rp+ lp

Assuming perfect information, pe is the same for all participants in the market, and this is identical to:

in = i*n + rp + lp

where

in is the nominal interest rate on a given investment
ir is the risk-free return to capital
i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S. Treasury Bills).
rp = a risk premium reflecting the length of the investment and the likelihood the borrower will default
lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).

An example of Money. ...

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, annualised.


The total interest on an investment depends on the timescale the interest is calculated on, because interest paid may be compounded. In finance, interest has three general definitions. ...


In 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. Finance studies and addresses the ways in which individuals, businesses and organizations raise, allocate and use monetary resources over time, taking into account the risks entailed in their projects. ... Yield may mean: In economics, yield is a measure of the amount of income an investment generates over time (related to return on investment). ...


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. Annual Percentage Rate (APR) is an expression of the effective interest rate that will be paid on a loan, taking into account one-time fees and standardizing the way this rate is expressed. ... In relation to the US: The Effective Annual Rate (EAR) is the interest rate that is annualized using compound interest, as opposed to using simple interest in the case of the Annual percentage rate (APR). ...


Money market mutual funds quote their rate of interest as the 7 Day SEC Yield. The introduction to this article provides insufficient context for those unfamiliar with the subject matter. ...


Interest rates in macroeconomics

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. Note that if interest rates are high, that means the broad economy is doing well and thus people will be willing to borrow money at higher interest rates. Invest redirects here. ... Measures of national income and output are used in economics to estimate the value of goods and services produced in an economy. ...


Interest rates are set by a government institution, usually a central bank, as the main tool of monetary policy. The institution offers to buy or sell money at the desired rate and, because of their immense size, they are able to effectively set i*n. Monetary policy is the government or central bank process of managing money supply to achieve specific goals—such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth. ...


By altering i*n, 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 to changes in interest rates, affecting national income. Invest redirects here. ...


Through Okun's Law changes in output affect unemployment. In economics, Okuns Law, named after economist Arthur Okun, describes a relationship between the change in the rate of unemployment and the difference between actual and potential real GDP. In the United States during the period since 1965 or so, Okuns Law can be stated as saying that... An 1837 political cartoon about unemployment in the United States. ...


Open Market Operations in the United States

The effective federal funds rate charted over fifty years

The Federal Reserve (often referred to as 'The Fed') implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. Open market operations are one tool within monetary policy implemented by the Federal Reserve to steer short-term interest rates. Using the power to buy and sell treasury securities, the Open Market Desk at the Federal Reserve Bank of New York can supply the market with dollars by purchasing T-notes, hence increasing the nation's money supply. By increasing the money supply or Aggregate Supply of Funding (ASF), interest rates will fall due to the excess of dollars banks will end up with in their reserves. Excess reserves may be lent in the Fed funds market to other banks, thus driving down rates. Description: Historical chart of the U.S. federal funds rate. ... Description: Historical chart of the U.S. federal funds rate. ... Monetary policy is the government or central bank process of managing money supply to achieve specific goals—such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth. ... The federal funds rate is the interest rate at which depository institutions lend balances (federal funds) at the Federal Reserve to other depository institutions overnight. ... Federal Funds transactions redistribute bank reserves. ... Open Market Operations are the means by which central banks control the liquidity of the national currency. ... Securities are tradeable interests representing financial value. ... The Federal Reserve Bank of New York, located at 33 Liberty Street in Manhattan. ... Federal Funds transactions redistribute bank reserves. ...


Money and inflation

Loans, bonds, and shares have some of the characteristics of money and are included in the broad money supply. An example of Money. ...


By setting i*n, 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. This means that interest rates can affect inflation in the future. In economics, the velocity of money refers to a key term in the quantity theory of money, which centers on the equation of exchange: M*V = P*Q where M is the total amount of money in circulation in an economy at any one time (say, on average during a...


Mathematical note

Because interest and inflation are generally given as percentage increases, the formulas above are approximations.


For instance,

in = ir + pe

can be stated accurately as:

ir = [(1 + in)/(1 + pe)] — 1

For the purposes of most economic analysis, logarithms of indices are taken, which means the formulae work as stated in the article. Logarithms to various bases: is to base e, is to base 10, and is to base 1. ... In economics and finance an index (for example a price index, a stockmarket index) is a benchmark of activity, performance or any evolution in general. ...


See also

The term discount rate is used in several different contexts: // Credit cards Main article: Merchant account The discount rate is a percentage of the dollar amount of the transaction that a merchant is charged for each credit card transaction. ... Finance studies and addresses the ways in which individuals, businesses and organizations raise, allocate and use monetary resources over time, taking into account the risks entailed in their projects. ... Macroeconomics is the economics sub-field of study that considers aggregate behavior, and the study of the sum of individual economic decisions. ... Monetary policy is the government or central bank process of managing money supply to achieve specific goals—such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth. ... The real interest rate is the interest rate charged to a risk free borrower, minus the inflation rate. ...

External links

  • Calculator
  • Up to date rate calculator (nfp)

  Results from FactBites:
 
Interest rate - Wikipedia, the free encyclopedia (1410 words)
Interest rates are normally expressed as a percentage over the period of one year.
Interest rates are the main determinant of investment on a macroeconomic scale.
Interest rates are set by a government institution, usually a central bank, as the main tool of monetary policy.
Interest rate parity - Wikipedia, the free encyclopedia (1354 words)
The interest rate parity is the basic identity that relates interest rates and exchange rates.
The covered interest parity states that the interest rate difference between two countries' currencies is equal to the percentage difference between the forward exchange rate and the spot exchange rate.
Thus the basic idea of covered interest arbitrage is to borrow in the country with lower interest rate and invest in the country with higher interest rate.
  More results at FactBites »

 
 

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