Interest rate

By:

James Knight

James is a lead editor for Invezz, where he covers topics from across the financial world, from the stock… read more.

Updated: Jan 20, 2023

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What is the interest rate?

Also known as the interest rate , it is the rate a borrower pays for the use of money they borrow from a lender.

For example, a company (borrower) borrows capital from a bank (lender) to buy new assets for its business, in exchange for lending the money, the lender receives interest at a predetermined rate. The interest rate, or interest rate , is normally expressed as a percentage of the principal for a given period, usually one year. In other words, it can be said that the lender charges for the temporary use of an asset owned by him (money).

Interest rates are a vital tool for Central Banks in their monetary policy and are taken into account when dealing with variables such as investment, inflation and unemployment.

History

The collection of interest can go back to very distant times, the first references may be those found in texts of the Abrahamic religions.

During the Middle Ages, the Catholic influence considered the collection of interest something unacceptable, it even fell within the sin of usury. This was because it is charged for the temporary use of a good and time was considered God’s property.

During the Renaissance, money begins to be seen like any other commodity and, therefore, can be bought, sold or leased. In this sense, the interest rate would be the payment for the lease of money.

During the development of classical economic theories came the first academic studies of the interest rate . The outstanding authors of this time 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 merchandise, the concept of financial capital is developed.

Already at the beginning of the 20th century, Irving Fisher studied interest rates mathematically, incorporating various factors that affect interest rates, introducing the differentiation between nominal interest rate and real interest rate. By introducing factors such as inflation, Fisher describes the interest rate in its quantitative and temporal dimension, indicating the interest rate as the function that measures the difference between the price of the good in the future and the price of the good in the present.

The most influential economists on the concept of the interest rate today are John Keyes and Milton Friedam.

Real interest rate and nominal interest rate

The type or nominal interest rate is the amount, in terms of money, of the interest to be paid.

For example, let’s say you make a term deposit of €100 in a bank for 1 year and receive €10 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 year. The real interest rate measures the purchasing power of interest income, that is, it takes inflation into account and is calculated by adjusting the nominal interest rate according to the inflation rate. If the rate of inflation in the economy has been 10% in that year, then the €110 in the account at the end of the year has the same purchasing power as the €100 a year ago. The real interest rate in this case is zero.

Converted to a mathematical expression, what has happened is described by the Fisher equation , which gives the real interest rate obtained after the period and once the inflation rate is known:

t = ((1 + i) / (1 + p)) – 1

where p = the rate of inflation during the year. The following linear approximation is widely used:

t ≈ i – p

The expected real return on an investment would be as follows:

i_r = i_n – p_e

where:

i _n = Nominal interest rate
i _r = real interest rate
p _e = Expected inflation rate for the year

Interest rates in the macroeconomy

Interest rates affect many other areas of the economy. Especially related to production and unemployment, money and inflation.

production and unemployment

Interest rates represent the main determinant of investment at the macroeconomic level. Current economic thought suggests that if interest rates increase in all areas, investment decreases, causing a fall in national income. However, there are discrepancies between some economists and others, for example, the Austrian School of Economics considers that high interest rates stimulate a greater degree of activity and investment in order to obtain the necessary profit to pay depositors, that is, it would increase investment, production, and with it employment, in order to obtain more benefits to pay, while economically non-productive credits, such as consumer credit or mortgage loans, would decrease.

From government institutions, usually the Central Bank of the country, money is lent to financial institutions at a certain interest rate. This Central Bank interest rate directly influences commercial interest rates, since financial institutions borrow money from the Central Bank, money that they then lend to their clients at an interest rate higher than the one they obtained the loan from the Central Bank. Therefore, the modification of the Central Bank’s interest rates affects commercial interest rates, among which are the interest rates of loans requested for investment, production and economic development purposes. 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

Loans, bonds, and stocks share some of the characteristics of money and are included in the broad money supply . By setting the interest rate, the Central Bank can affect the market by altering the total number of loans, bonds and shares issued and, with it, the money supply. In general, a higher real interest rate reduces money resources while lower interest rates will increase the money supply. The increase in the money supply, according to the quantity theory of money, leads to an increase in inflation.

Central bank interest rate

The most obvious, visible and powerful tool of Central Banks in their monetary policy is the influence on commercial interest rates, as mentioned above. The mechanism through which they carry out this action may be different from one country to another, but all are based on the ability of the central bank to increase or decrease the available monetary resources according to need.

The mechanism to move the market towards a “target rate” (if this objective is pursued, as is the case with most Central Banks) is, in general, to lend money or buy money in theoretically unlimited amounts until the rate of target market is close enough to the target. Central banks can do this by lending money or taking deposits from a limited number of qualified banks, or by buying and selling bonds. For example, the Bank of Canada sets an interest rate target of ±0.25% in the overnight market. Qualified banks can lend money to each other at an interest rate within this band but never above or below as the central bank always lends to them at the 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 this band is unlimited. Other central banks use similar mechanisms.

Also keep in mind that interest rate targets are generally short-term. The actual rate that borrowers and lenders receive in the market will depend primarily on perceived credit risk and other factors. For example, a central bank may set a target rate for overnight loans at 4.5%, but set five-year bond rates (similar risk) at a different rate, say 5%, 4.75 %, or, in cases of inverted yield curves, even below the short-term rate. Many central banks have a main interest rate which is referred to as the “central bank rate”. In practice, central banks have other tools and can use other interest rates, although only one, the so-called “central bank rate”, is rigorously controlled according to its objectives.

A typical central bank has various interest rates or monetary policy instruments that it can use to influence the markets.

• Marginal lending rate – a fixed interest rate for institutions that borrow from the central bank. (in some countries it is known as discount rate).
• Main financing rate – the interest rate visible to the public, the one announced by the central bank. It is also known as the minimum bid rate and serves as the bidding minimum for loan refinancing. (In the United States it is known as Federal Funds Rates).
• Passive interest rate – interest received on deposits in the central bank.

These fees directly affect interest rates in the money market and the short-term loan market.

Negative interest rates

Interest rates are usually positive, in fact, no lender will give a loan with a negative interest rate, since it would entail, almost 100%, a loss. Even a 0% loan would likely create a real loss for the lender due to the loss of purchasing power of money over time due to inflation.

However, negative interest rates have been proposed by some authors throughout history to pursue various objectives (for example Silvio Gesell in the 19th century). In 2009, an interest rate of -0.25% from the Sveriges Riksbank (Central Bank of Sweden) materialized. This was the first time in history that a central bank set a negative interest rate.

In January 2013, Germany was able to finance its public debt at a negative interest rate. The investor in German bonds saw his investment partially insured by the German government in an unstable economic climate in Europe with the risk even of the disappearance of the euro. The debt bonds of Germany were the safest at that time and it could be said that the investor “paid” for that security.