Interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed. Interest rate periods are ordinarily a year and are often annualized when not. Alongside interest rates, three other variables determine total interest: principal sum, compounding frequency, and length of time.
Interest rates reflect a borrower's willingness to pay for money now over money in the future. In debt financing, companies borrow capital from a bank, in the expectation that the borrowed capital may be used to generate a return on investment greater than the interest rates. Failure of a borrower to continue paying interest is an example of default, which may be followed by bankruptcy proceedings. Collateral is sometimes given in the event of default.
In monetary policy and macroeconomics, the term "interest rate" is often used as shorthand for a central bank's policy rate, such as the United States Federal Reserve's federal funds rate. "Interest rate" is also sometimes used synonymously with overnight rate, bank rate, base rate, discount rate, coupon rate, repo rate, prime rate, yield to maturity, and internal rate of return.
Definitions
Real versus nominal
The nominal interest rate is the interest rate without adjusting for inflation, whereas the real interest rate takes inflation into account. Real interest rates measure the interest accumulated and repayment of principal in real terms by comparing the sum against the buying power of the amount at the time it was borrowed, lent, deposited or invested. Where inflation is the same as nominal interest rate, the real interest rate is zero.The real interest rate is given by the Fisher equation:
where p is the inflation rate.
For low rates and short periods, the linear approximation applies:
The Fisher equation applies both ex ante and ex post. Ex ante, the rates are projected rates, whereas ex post, the rates are historical.
Other rates
The term "interest rate" is also often used as shorthand for a number of specific rates, most commonly the overnight rate, bank rate, or other interest rate set by a central bank. In this regard, the United States Federal Reserve's Federal Funds Rate is often simply known as the "interest rate" or "rate", due to its global macroeconomic and financial significance. In United Kingdom contexts, Official Bank Rate of the Bank of England is also known as "the interest rate". "Interest rate" is also sometimes used synonymously with base rate, discount rate, coupon rate, repo rate, prime rate, yield to maturity, internal rate of return, spot rate, forward rate, and benchmark rates such as Libor and SONIA.Base rate usually refers to the annualized effective interest rate offered on overnight deposits by the central bank or other monetary authority.
The annual percentage rate may refer either to a nominal APR or an effective APR. The difference between the two is that the EAPR accounts for fees and compounding, while the nominal APR does not.
The annual equivalent rate, also called the effective annual rate, factors into account compounding frequencies of products, but does not account for fees.
Discount rate can both refer to the discount window of central banks and more generally as the annual rate used to discount future values into present value.
For an interest-bearing security, coupon rate is the ratio of the annual coupon amount per unit of par value, whereas current yield is the ratio of the annual coupon divided by its current market price.
Yield to maturity is a bond's expected internal rate of return, assuming it will be held to maturity, that is, the discount rate which equates all remaining cash flows to the investor with the current market price.
Based on the relationship between supply and demand of market interest rate, there are fixed interest rate and floating interest rate.
Monetary policy
Interest rate targets are a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment. The central banks of countries generally tend to reduce interest rates when they wish to increase investment and consumption in the country's economy. However, a low interest rate as a macro-economic policy can be risky and may lead to the creation of an economic bubble, in which large amounts of investments are poured into the real-estate market and stock market. In developed economies, interest-rate adjustments are thus made to keep inflation within a target range for the health of economic activities or cap the interest rate concurrently with economic growth to safeguard economic momentum.History
In the past two centuries, interest rates have been variously set either by national governments or central banks. For example, the Federal Reserve federal funds rate in the United States has varied between about 0.25% and 19% from 1954 to 2008, while the Bank of England base rate varied between 0.5% and 15% from 1989 to 2009, and Germany experienced rates close to 90% in the 1920s down to about 2% in the 2000s. During an attempt to tackle spiraling hyperinflation in 2007, the Central Bank of Zimbabwe increased interest rates for borrowing to 800%.The interest rates on prime credits in the late 1970s and early 1980s were far higher than had been recorded – higher than previous US peaks since 1800, than British peaks since 1700, or than Dutch peaks since 1600; "since modern capital markets came into existence, there have never been such high long-term rates" as in this period.
Before modern capital markets, there have been accounts that savings deposits could achieve an annual return of at least 25% and up to as high as 50%.
Influencing factors
- Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on 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, die, 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 to realize.
- 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.
- Banks: Banks can tend to change the interest rate to either slow down or speed up economy growth. This involves either raising interest rates to slow the economy down, or lowering interest rates to promote economic growth.
- Economy: Interest rates can fluctuate according to the status of the economy. It will generally be found that if the economy is strong then the interest rates will be high, if the economy is weak the interest rates will be low.
Zero rate policy
In the United States, the policy was used in 2008-2015, following the 2008 financial crisis, and 2020-2022, during the COVID-19 pandemic.
Negative nominal or real rates
Nominal interest rates are normally positive, but not always. In contrast, real interest rates can be negative, when nominal interest rates are below inflation. When this is done via government policy, this is known as financial repression, which was practiced by countries such as the United States and United Kingdom following World War II until the late 1970s or early 1980s, during and following the Post–World War II economic expansion. In the late 1970s, United States Treasury securities with negative real interest rates were deemed certificates of confiscation.A so-called "negative interest rate policy" is a negative central bank target interest rate.
Theory
In theory, profit-seeking lenders will not lend below 0% if given the alternative of holding cash, as that will guarantee a loss. Likewise, a bank offering a negative deposit rate will find few takers, as savers will instead hold cash.Negative interest rates have been proposed in the past, notably in the late 19th century by Silvio Gesell. A negative interest rate can be described as a "tax on holding money"; Gesell proposed it as the Freigeld component of his Freiwirtschaft system. To prevent people from holding cash, Gesell suggested issuing money for a limited duration, after which it must be exchanged for new bills; attempts to hold money thus result in it expiring and becoming worthless. Along similar lines, John Maynard Keynes approvingly cited the idea of a carrying tax on money, but dismissed it due to administrative difficulties. In 1999, a carry tax on currency was proposed by Federal Reserve employee Marvin Goodfriend, to be implemented via magnetic strips on bills, deducting the carry tax upon deposit, the tax being based on how long the bill had been held.
It has also been proposed that a negative interest rate can in principle be levied on existing paper currency via a serial number lottery, such as randomly choosing a number 0 through 9 and declaring that notes whose serial number end in that digit are worthless, yielding an average 10% loss of paper cash holdings to hoarders; a drawn two-digit number could match the last two digits on the note for a 1% loss. This was proposed by an anonymous student of Greg Mankiw, though more as a thought experiment than a genuine proposal.