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Interest Rates

An interest rate can be defined as the amount a borrower pays a lender for the use of money that is not owned by them. For example, a small business might borrow from a bank to start their business, and the lender receives a return for allowing to use their funds. Interest rates can be stated as a percentage rate during a one year period. Interest rates can also be used as a monetary policy where variables such as inflation, investment and unemployment can be controlled. The government or the central bank generally sets the interest rates.

The compound interest rate is set when the compounding is yearly and if there is a convention in economics there will be a disclosure of the interest rate. At the compound level, interest rates are shown how to be converted forward and backward from the various measures of interest when lending interest rates are nominal. A problem that can arise from compound interest is that it causes difficulty in interpretation. This is when the convention in economics is used in order to simplify this problem. The term is taken as one year, with an annual compounding.

When the interest rate does not change it is known as a fixed rate. In case there is a change that occurs usually with a margin, either plus or minus it is known as a floating rate, variable rate or adjustable rate. In the case of a loan combinations of both the floating rate and fixed rate are commonly used. Various interest rates are applied on loans, where the changes made to the interest rate are regulated by certain specific government standards. For example, a loan that makes use of a certain time period to allow for specific changes in the interest rate such as ten percent in the first year, twelve percent in the second and fifteen percent in the third year.


Interest can be subjected to misleading figures due to inflation. The interest rate which is nominal is what is visible to consumers before the adjustment of the price. In case of nominal interest rate, it involves inflation which is added to the interest rate.

Given below are a few causes of the occurrence of interest rates.

• Deferred consumption, people have a preference for good now than later, where in the free market this will promote an interest rate that is positive
• Inflation expectations, in an economy that exhibits inflation, the borrow will compensate the lender for this circumstance, where the amount of money given will purchase less goods in the future than it does now.
• Alternative investments, the lender can choose how he wants to use his money in various investments. He will forgo many in order to choose one borrower. Investments of diverse nature compete for funds effectively
• Risks of investments, the risk that the borrower might end up bankrupt, default on their loan or abscond will be a lender’s risk. A lender will charge a fee that is a risk premium to ensure that he compensated in case of the above.
• Liquidity preference, it is preferential to have liquidity in hand rather than have to wait for money and time to realize
• Taxes, higher interest rates compensate when it is sometimes subjected to taxes

Tags: bank, Economics, government, interest rates, liquidity, loan, market, money, policy, price, risk, tax

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