Interest Rate

An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited, or borrowed.

The annual interest rate is the rate over a period of one year. Other interest rates apply over different periods, such as a month or day, but they are usually annualized.

The interest rate has been characterized as "an index of the preference . . . for a dollar of (present) income over a dollar of future income." The borrower wants, or needs, to have money sooner rather than later, and is willing to pay a fee - the interest rate - for that privilege.

Interest rates vary according to:

• the government's directives to the central bank to accomplish the government's goals
• the currency of the principal sum lent or borrowed
• the term to maturity of the investment
• the perceived default probability of the borrower
• supply and demand in the market
• the amount of collateral
• special features like call provisions
• reserve requirements
• compensating balance

as well as other factors.

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 intetest 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.

Reasons for the change in interest rates include:

• 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 of 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 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 resouces 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 interest rate to either slow down or speed up economic 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, and if the economy is weak then the interest rates will be low.

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