An interest rate is the price a borrower pays for the use of money they borrow from another burrowee, for instance a small company might borrow capital from a bank to buy new assets for their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower. Interests rates are fundamental to a Capitalist society. Interest rates are normally expressed as a percentage rate over the period of one year.
Interest rates targets are also a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment.
Interest rates are directly correlated to the performance of the world economy. Government officials craft monetary policy to manage national economies by influencing the banking system. At the micro-level, investors and private consumers should have some appreciation for the connection between interest rates and the economy before making financial decisions.
Identification
Interest rates are referred to as the “cost of money.” Lenders that offer capital for investment are compensated with interest payments from borrowers.
Features
Interest rates measure risks. Lenders demand additional compensation for lending capital to riskier borrowers. Investors also expect to earn a premium that is higher than the rate of inflation to make any transaction worthwhile.
Asset Prices
Interest rates help to establish asset prices in a free-market economy. Prospective home buyers often will refuse to buy new homes because of high interest rates; housing prices then must fall to attract buyers. Additionally, high interest rates attract investors to the safety of interest-bearing bonds–at the expense of riskier common stock ownership.
Intervention
Central banks intervene through open market transactions and management of banking reserve requirements to affect interest rates and the economy. Higher interest rates slow growth and manage inflation. Lower interest rates are intended to counter recessions and promote growth by encouraging additional borrowing.