Definition

The interest rate is the amount of interest due per period, as a proportion of the principal (the amount lent, deposited or borrowed). It consists of the percentage expression of the portion of the principal that the lender charges to the borrower as interest. The entity of the sum that the borrower will have to pay as an interest to the buyer depends on the four following factors: principal sum, interest rate, compounding frequency, and the length of time.

Interest rates are one of the main tools of monetary policy, which consists of the sum of decisions taken by the monetary authority of a country, usually the central bank, in order to influence the economy and achieve its objectives. 

In fact, they are one of the most influential factors that influence the economy and have important consequences for the health of the economy, because they influence the decision making of individuals and firms.

Example

In order to better understand what interest rates are, let’s look at the following example:

Suppose that your friend Mark wants to buy a new car that costs $10,000 but, on his bank account, he has only half of that amount, $5,000. Therefore, Mark asks you to lend him the other $5,000 so that he will be able to buy the car, he promises to pay back the money in one year.

Mark is your good friend and you have some extra money in your bank account that you do not immediately need, therefore you agree to lend him the money he asks for, but on one condition, you want to earn some return on this money, a return that justifies the fact that you will not be able to use that money for other purposes for one entire year. Therefore you make some calculations and decide that $100 is for you a sufficient return.

In this case, you have set a 2% interest rate, therefore, after one year, Mark will have to pay you back the $5,000 dollars plus the 2% interest, which is $100 dollars.

In another situation where, for example, your friend Sarah asks you for the same amount of money and for a similar purpose, but you know that she is not really good with money and that there is a chance that she will not pay back the loan, you may decide that, in order to justify the risk of lending to her, you want to receive a higher return.

In this case, you will set a higher interest rate, say 5%, and therefore you will receive $250 that should balance the greater risk.

Nominal vs Real interest rates

In the first place, it is important to understand the difference between nominal and real interest rates, because otherwise every analysis and calculation can become pointless, especially when making decisions about investments.

Usually, when talking about interest rates, we refer for the sake of simplicity to the nominal interest rate which however does not take into consideration the effects that inflation can have on returns.

Therefore, it is important to distinguish the nominal interest rate from the real interest rate, which is is the interest rate that takes into account the expected changes in inflation, and therefore it is more accurate and can better reflect the true cost of borrowing.

For example, suppose that you borrow $1,000 for one year and you agree to pay an interest of 5% at the end of the year, which means that you will have to repay a total of $1,050.

However, due to an excessive increase in the money supply from the central bank, inflation goes up and at the end of the year it reaches 10%, this means that, in this case, while the nominal interest rate is 5%, the real interest rate is -5%, therefore even though you repay the entire loan, every dollar that you repay can buy 10% fewer goods than when you and the bank agreed to the terms of the loan.

This means that the bank, even if in nominal terms has 5% more money, the buying power of that money is lower by 5% than when it lends it to you, which means that the bank has lost money.

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