What is the interest rate?
The interest rate is the rate paid by a borrower for the use of money borrowed from a lender.
For example, a company (borrower) asks borrowed capital to a bank (lender) to buy new assets for their businesses, in exchange for lending money, the lender receives interest at a predetermined rate. The interest rate is usually expressed as a percentage of capital for a certain period, usually a year. In other words, we can say that the lender charges for the temporary use of a property owned (the money).
Interest rates are a vital tool of central banks in monetary policy and are taken into account when variables like investment, inflation and unemployment are treated.
The interest charges can be traced back to very ancient times, the first references may be found in the texts of the Abrahamic religions.
During the Middle Ages the Catholic influence considered unacceptable charging interest, even falling into the sin of usury. This was because the charge for temporary use of a good and time was considered the property of God.
During the Renaissance we start to see money like any other commodity and thereforeit can be bought, sold or leased. In this sense, the interest rate would be the lease payment of money.
During the development of the classical economic theories came the first academic study of the interest rate. The lead authors of this era in the study of the interest rate were Mirabeau, Jeremy Bentham and Adam Smith, for whom money, as a commodity, was subject to the laws of supply and demand. Thus, the interest rate could be considered as the “price of money”. In this line of money as a commodity the concept of financial capital is developed.
Since the early twentieth century, Irving Fisher studied interest rates mathematically incorporating various factors affecting interest rates, introducing the distinction between nominal interest rate and real interest rate. By introducing factors such as inflation, Fisher describes the interest rate on its quantitative and temporal dimension noting the interest rate as the function that measures the difference between the price of the good in the future and the price of good in the present.
The most influential economists in the concept of the interest rate today is John Milton Keyes and Friedam.
Real interest rate and nominal interest rate
The nominal interest rate is the amount in terms of money, of interest payable.
For example, suppose a term deposit of $100 in a bank is done for 1 year and the depositor get $10 of interest for that money and that period. At the end of the year the balance is $110. In this case, the nominal interest rate is 10% per annum. The real interest rate measures the purchasing power of the interest income, ie, takes into account inflation and is calculated by adjusting the nominal interest rate according to the inflation. If the inflation rate in the economy was 10% in that year, then the $110 is in the account at the end of the year have the same purchasing power as $100 of a year ago. The real interest in this case is zero.
Translated to a mathematical expression, what has happened is described by the Fisher equation, which gives the real interest earned one the time period is elapsed and the the inflation rate is known:
- in = Nominal interest rate
- ir = Real interest rate
- pe = Expected inflation rate for the year
Interest rates in macroeconomics
Production and unemployment
Interest rates are the main determinant of investment at the macro level. The current economic thinking suggests that if interest rates increase across the board investment decreases causing a drop in national income. However, there are discrepancies between some economists and others, for example, the Austrian School of Economics believes that high interest rates stimulate greater activity and investment in order to achieve the necessary benefits to pay depositors, that is, increase investment, production, and thus employment, to pay more benefits, while non-economically performing loans as consumer loans or mortgages would decline.
From government institutions, usually the central bank, the goverment lends money to financial institutions at a certain interest rate. This interest rate of the central bank directly influences the commercial interest rates because financial institutions borrow money from the central bank, and these institutions lend this money to their customers at a higher interest rate than the one they obtained from the Central Bank. Therefore, changes in interest rates of the central bank affects commercial interest rates, among which are the interest rates of loans for investment, production and economic development. This is why changes in the interest rate of the central banks can cause rapid changes in the level of investment and total production.
Money and inflation
Interest rates of Central Bank
The most obvious, visible and powerful tool of central banks in monetary policy is the influence on commercial interest rates, as mentioned above. The mechanism through which the central banks carry out this action may differ from one country to another but all rely on the central bank’s ability to increase or decrease the monetary resources available as needed.
The mechanism for moving the market toward a “target rate” (if this goal is pursued, as is the case for most of Central Banks) is usually lend or buy money in amounts theoretically unlimited until the rate of target market is sufficiently close to the target.. Central banks can do so by borrowing money or taking deposits from a limited number of qualified banks or by buying and selling bonds. For example, the Bank of Canada sets a target interest rate of ± 0.25% in the overnight market. Qualified banks can borrow from each other at an interest rate within this band but never above or below as the central bank always pay them on top of the band and takes deposits at the bottom of the band; in principle, the ability to borrow or lend at the ends of the band are limitless. Other central banks use similar mechanisms.
Also keep in mind that interest rate objectives are usually short term. The actual rate that borrowers and lenders receive in the market depends maninly on the perceived credit risk and other factors. For example, a central bank can set a target rate for overnight loans of 4.5%, but at the same time set a five-year bonds rate (similar risk) to a different rate, for example 5%, 4.75 %, or, in cases of inverted yield curves, even below the short-term rate. Many central banks have a key interest rate that is referred to as the “central bank rate”. In practice, central banks have other tools and can use other interest rates although only one, called “central bank rate” is tightly controlled by its objectives.
A typical central bank has several interest rates or monetary policy instruments that can be used to influence markets.
- Marginal lending rate – a fixed interes rate for institutions that borrow from the central bank. (in some countries known as discount rate).
- Main financing rate – the interest rate visible to the public and announced by the central bank. It is also known as minimum bid rate and serves as the minimum bid for refinancing loans. (In the United States known as Federal Funds Rates).
- Passive interest rate – interest received on deposits at the central bank.
Negative interest rates
Interest rates are usually positive, in fact, no lender will give a loan with a negative interest rate as this would lead, almost 100% to a loss. Even a loan at 0% would probably generate a real loss for the lender because of the loss of purchasing power of money over time because of inflation.
However the negative interest rates have been proposed by some authors throughout history to pursue several objectives (eg Silvio Gesell in the nineteenth century). In 2009 an interest rate of -0.25% of the Sveriges Riksbank (Bank of Sweden) materialized. This was the first time in history that a central bank established a negative interest rate.
In January 2013 Germany was able to finance its public debt with a negative interest rate. The investor in German bunds saw their investment partially guaranteed by the German government in an unstable economic climate in Europe with the risk of even the disappearance of the euro. The debentures of Germany were the safest for those dates and you could say that the investor “paid” in exchange for that security.