Interest rate
Interest rates are the price of borrowing money.
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 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.
- field
- Finance, economics, monetary policy
- known_for
- Central tool in monetary policy; affects investment, inflation, and unemployment
- key_variants
- Nominal rate, real rate, base rate, discount rate, coupon rate, yield to maturity
- policy_application
- Zero interest-rate policy (ZIRP) used in 2008-2015 and 2020-2022
Lore & Background
Interest rates have been variously set by national governments or central banks over the past two centuries. Germany experienced rates close to 90% in the 1920s down to about 2% in the 2000s. The nominal interest rate is the interest rate without adjusting for inflation, whereas the real interest rate takes inflation into account. The real interest rate is given by the Fisher equation. For low rates and short periods, the linear approximation r ≈ i − p applies. The Fisher equation applies both ex ante and ex post. Interest rate targets are a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment. Central banks generally tend to reduce interest rates when they wish to increase investment and consumption. However, a low interest rate as a macro-economic policy can be risky and may lead to the creation of an economic bubble.
Reader's Guide
Interest rates are fundamental to modern finance and macroeconomics. They determine the cost of borrowing and the return on savings, influencing decisions by consumers, businesses, and governments. Central banks use interest rate targets as a primary tool of monetary policy to manage inflation, investment, and unemployment. The concept encompasses many specific rates—such as the federal funds rate, base rate, discount rate, and yield to maturity—each serving distinct purposes in financial markets. The Fisher equation distinguishes nominal from real rates by accounting for inflation. A zero interest-rate policy (ZIRP) has been employed during crises, such as after the 2008 financial crisis and during the COVID-19 pandemic. Factors influencing interest rates include deferred consumption, inflationary expectations, alternative investments, risk of default, liquidity preference, taxes, and political short-term gain. Understanding interest rates is essential for grasping how economies allocate capital, manage growth, and respond to shocks.
Did You Know?
- The real interest rate is zero when inflation equals the nominal interest rate.
- The United States Federal Reserve's federal funds rate is often simply known as the 'interest rate' due to its global significance.
Frequently Asked Questions
What is an interest rate in plain terms?
It is the price tag attached to borrowing money, expressed as a percentage of the principal per period. Think of it as what a borrower agrees to pay for using someone else's cash now instead of later.
What role does the interest rate play in the broader economy?
It functions as the central lever of monetary policy, nudging investment decisions, inflation, and employment all at once. Central banks adjust this single benchmark to steer the entire financial system toward their targets.
What are the main variants of interest rates a fan should know?
Key types include nominal rate, real rate, base rate, discount rate, coupon rate, and yield to maturity, each capturing a slightly different slice of borrowing cost. Alongside principal, compounding frequency, and time, they together determine the total interest owed.
How does the interest rate connect to the Federal Reserve?
In everyday macroeconomic talk, 'the interest rate' is often shorthand for the Fed's policy rate, the benchmark that cascades into mortgages, business loans, and savings accounts. It is the Fed's primary instrument for taming inflation and supporting jobs.
What was the Zero Interest-Rate Policy (ZIRP) and when did it occur?
ZIRP is a stance in which a central bank drives its policy rate to near zero to jump-start a sluggish economy. The Fed adopted this approach in two stretches: 2008–2015 after the financial crisis and 2020–2022 during the pandemic.
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