An interest rate is the price a borrower pays for the use of money they do not own, for instance a small company might borrow from a bank to kick start their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower. 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 used to control variables like investment, inflation, and unemployment.

Historical interest rates

Interest rates throughout history have been variously set either by national governments or central banks. For example, the Federal Reserve federal funds rate in the United States has varied between about 0.25% to 19% from 1954 to 2008, while the Bank of England base rate varied between 0.5% and 15% from 1989 to 2009, and Germany experienced rates close to 90% in the 1920s down to about 2% in the 2000s. During an attempt to tackle spiralling hyperinflation in 2007, the Central Bank of Zimbabwe increased interest rates for borrowing to 800%.

Causes of interest rates

• Deferred consumption. When money is loaned the lender delays spending the money on consumption 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 she chooses one, she forgoes the returns from all the others. Different investments effectively compete for funds.

• Risks of investment. There is always a risk that the borrower will go bankrupt, abscond, 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 resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realise.

• 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.

Real vs nominal interest rates

The nominal interest rate is the amount, in money terms, of interest payable.

For example, suppose a household deposits $100 with a bank for 1 year and they receive interest of $10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum.

The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account. (See real vs. nominal in economics.)