Interest Rate
What is Interest Rate?
An interest rate is the cost of borrowing money or the reward for saving it, expressed as a percentage of the principal per year.
Interest rates are set in money and loanable-funds markets and steered by the central bank. Lower rates encourage borrowing, investment, and spending; higher rates encourage saving and slow the economy. The real interest rate (nominal minus inflation) reflects the true cost of borrowing.
Interest Rate: a worked example
A saver deposits 800 dollars for one year at a nominal interest rate of 7 percent. Interest earned is 800 × 0.07 = 56 dollars, leaving a balance of 856 dollars. If prices rose 5 percent over the same year, the real interest rate is roughly 7 - 5 = 2 percent, so purchasing power grew by about 800 × 0.02 = 16 dollars rather than by the full 56. The exact calculation deflates the balance: 856 ÷ 1.05 = 815 dollars of start of year buying power, a real gain of 15 dollars, or 1.9 percent. Read from the borrower's side, the same figures mean a firm that borrowed 800 dollars handed back only about 15 dollars of real resources beyond what it borrowed.
The mistake students make with interest rate
Unexpected inflation gets pinned on the borrower. Higher prices sound like a burden, so students write that a surprise jump in inflation makes a loan harder to repay. The repayment is a fixed number of dollars, and those dollars now buy less, so the borrower hands over less real value than either side expected and the lender receives less. Had inflation arrived at 9 percent instead of 5 in the deposit above, the 7 percent nominal rate would have left the saver about 2 percent worse off in real terms and the borrower ahead by that same margin.
Interest Rate questions
What is the difference between the nominal and real interest rate?
The nominal interest rate is the stated percentage a lender charges or a bank pays, with no adjustment for changing prices. The real interest rate subtracts inflation and measures the change in actual purchasing power. A saver earning 6 percent while prices rise 4 percent gains about 2 percent in real buying power. Lenders watch the real rate because it decides whether the money repaid buys more than the money lent.
How do interest rates affect investment spending?
Higher interest rates raise the cost of borrowing, so firms drop projects whose expected return no longer clears the hurdle. A warehouse expected to return 6 percent is worth financing at 4 percent and not at 8 percent, which is why the investment demand curve slopes downward against the interest rate. Households respond the same way on mortgages and car loans. Lower rates pull investment and interest sensitive consumption up, expanding aggregate demand.
Why do borrowers face different interest rates?
Lenders price three things into a rate: the risk that the borrower fails to repay, the length of the loan, and the inflation expected over that stretch. A new firm with no repayment record pays more than a government that has never missed a payment, and a thirty year loan usually costs more than a one year loan because more can go wrong. A central bank policy rate therefore anchors a whole ladder of rates rather than setting each one.
This is the live Loanable Funds sandbox. Drag the curves, or open the full version.
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