 

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.
Interest RateAn 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. Interest rates are also a vital tool of monetary policy and are used to control variables like investment, inflation, and unemployment.
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. Real vs nominal interest ratesThe 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. The real 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 economics.) 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.
After the fact, the 'realized' real interest rate, which has actually occurred, is: where p = the actual inflation rate over the year.
The expected real returns on an investment, before it is made, are:
where: Market interest ratesThere is a market for investments which ultimately includes the money market, bond market, stock market and currency markets as well as retail financial institutions like banks.
Exactly how these markets function is a complex question. However, economists are generally agreed that the interest rates that any investment yields take into account, amongst other things: Riskfree cost of capitalThe riskfree cost of capital is the real interest on a riskfree loan. While no loan is ever entirely riskfree, bills issued by major nations like the USA are generally regarded as riskfree benchmarks. This rate incorporates the deferred consumption and alternative investments elements of interest. Inflationary expectationsAccording 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.
This is given by the formula:
where: RiskThe 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 bank deposits. 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. If an investment is 50% likely to go bankrupt, a riskneutral lender will require their returns to double. So for an investment normally returning $100 they would require $200 back. A riskaverse lender would require more than $200 back and a riskloving lender less than $200. Evidence suggests that most lenders are in fact riskaverse. Generally speaking a longerterm investment carries a maturity risk premium, because longterm loans are exposed to more risk of default during their duration. Liquidity preferenceMost 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 10year loan, for instance, is very illiquid compared to a 1year loan. A 10year US Treasury bond, however, is liquid because it can easily be sold on the market. A market interestrate model
A basic interest rate pricing model for an asset
Assuming perfect information, pe is the same for all participants in the market, and this is identical to: Interest rate notationsWhat 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, 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. 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. Interest rates in macroeconomicsOutput and unemploymentInterest 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. Interest rates are set by the Government or by a Central Bank as the main tool of monetary policy. The Government or central bank offers to buy and sell money at the desired rate, and because of their immense size they are able to effectively set i*n. By altering i*n, the Government/central bank 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. Through Okun's Law changes in output affect unemployment. Money and inflationLoans, bonds, and shares have some of the characteristics of money and are included in the broad money supply. By setting i*n, the Government or central bank 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. Mathematical noteBecause interest and inflation are generally given as percentage increases, the formulas above are approximations.
For instance, For the purposes of most economic analysis, logarithms of indices are taken, which means the formulae work as stated in the article.
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