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Interest Rates Defined
It is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. Interest rates are normally expressed as a percentage over the period of one year.
Interest rates are also a vital tool of monetary policy and are used to control variables like investment, inflation, and unemployment.
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 intreest 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 he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds, itnerest.
• 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.
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Market interest rates
There is a market for investments which ultimately includes the money market, bond market, stock market and currency market as well as retail financial institutions like banks.
Exactly how these markets function is a complex question. However, economists generally agree that the interest rates yielded by any investment take into account:
• The risk-free cost of capital interset rate
• Inflationary expectations
• The level of risk in the investment
• The costs of the transaction
See:
nominal interest rate
Effective annual rate
• Interest rates
• Annual percentage rate
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This article is licensed under the GNU
Free Documentation License. It uses material from the
Wikipedia
article "Interest Rates".
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