Skip to main content

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.
x----------x

This post is sponsored by Nike gym shoes.

Comments

Post a Comment

Popular posts from this blog

How to Create a Richly Imagined World

For someone who likes fantasy and sci-fi fiction, most of the time, a lot of people ask me about how to create a richly imagined world. Fantasy and sci-fi elements rest heavily on how an author weave the setting and the world in which the heroes dwell in, and it helps to make the novel to be imagined vividly in the readers' minds. A convincing world should be relatable, something that we can associate ourselves with. For us to be associated with a world an author created in his mind, and wrote on the pages of a book, this world has to be close to the real thing. It has to be systematic, real and alive, and very convincing. A real world has certain elements, and an author must consider them in writing a vividly imagined world: Cartography - a fantasy or sci-fi world depend heavily on geography and maps, especially if the plot requires war and the belligerents occupy so much space in the plot. A convincing world has the world separated in territories, and every part of the...
Post a Comment
Read more

Simple Machine

A simple machine is a mechanical device that changes the direction or magnitude of a force. In general, they can be defined as the simplest mechanisms that use mechanical advantage (also called leverage) to multiply force. Usually the term refers to the six classical simple machines that were defined by Renaissance scientists: Lever Wheel and axle Pulley Inclined plane Wedge Screw A simple machine uses a single applied force to do work against a single work load. Ignoring friction losses, the work done on the load is equal to the work done by the applied force. The machine can increase the amount of the output force, at the cost of a proportional decrease in the distance moved by the load. The ratio of the output to the applied force is called the mechanical advantage. Simple machines can be regarded as the elementary "building blocks" of which all more complicated machines (sometimes called compound machines) are composed. For example, wheels, levers, and pulleys are all use...
Post a Comment
Read more

Crusades

 The Crusades were a series of religious wars initiated, supported, and sometimes directed by the Christian Latin Church in the medieval period. The best known of these military expeditions are those to the Holy Land in the period between 1095 and 1291 that were intended to conquer Jerusalem and its surrounding areas from Muslim rule. Beginning with the First Crusade, which resulted in the conquest of Jerusalem in 1099, dozens of military campaigns were organized, providing a focal point of European history for centuries. Crusading declined rapidly after the 15th century. In 1095, Pope Urban II proclaimed the first expedition at the Council of Clermont. He encouraged military support for Byzantine emperor Alexios I Komnenos and called for an armed pilgrimage to Jerusalem. Across all social strata in western Europe there was an enthusiastic response. Participants came from all over Europe and had a variety of motivations, including religious salvation, satisfying feudal obligations,...
Post a Comment
Read more