Interest Rates and

Their Role in
Finance
 CONCEPT OF INTEREST
RATE

The interest rate is the amount a lender charges

for the use of assets expressed as a percentage
of the principal. The interest rate is typically
noted on an annual basis known as the annual
percentage rate (APR). The assets borrowed
could include cash, consumer goods, or large
assets such as a vehicle or building.
KEY TAKEAWAYS

-The interest rate is the amount charged on top of the principal by a lender
to a borrower for the use of assets.
-Most mortgages use simple interest. However, some loans use compound
interest, which is applied to the principal but also to the accumulated
interest of previous periods.
-A loan that is considered low risk by the lender will have a lower interest
rate. A loan that is considered high risk will have a higher interest rate.
-Consumer loans typically use an APR, which does not use compound
interest.
-The APY is the interest rate that is earned at a bank or credit union from a
savings account or certificate of deposit (CD). Savings accounts and CDs use
compounded interest.
 Understanding Interest Rates
Interest is essentially a rental or leasing charge to the
borrower for the use of an asset. In the case of a large asset,
such as a vehicle or building, the lease rate may serve as
the interest rate. When the borrower is considered to be
low risk by the lender, the borrower will usually be charged a
lower interest rate. If the borrower is considered high risk,
the interest rate that they are charged will be higher. Risk is
typically assessed when a lender looks at a potential
borrower's credit score, which is why it's important to have
an excellent one if you want to qualify for the best loans.
For loans, the interest rate is applied to the
principal, which is the amount of the loan. The
interest rate is the cost of debt for the borrower
and the rate of return for the lender.
When Are Interest Rates Applied?
Interest rates apply to most lending or borrowing
transactions. Individuals borrow money to purchase homes,
fund projects, launch or fund businesses, or pay for college
tuition. Businesses take loans to fund capital projects and
expand their operations by purchasing fixed and long-term
assets such as land, buildings, and machinery. Borrowed
money is repaid either in a lump sum by a pre-determined
date or in periodic installments.
The money to be repaid is usually more than the
borrowed amount since lenders require
compensation for the loss of use of the money
during the loan period. The lender could have
invested the funds during that period instead of
providing a loan, which would have generated
income from the asset. The difference between
the total repayment sum and the original loan is
the interest charged. The interest charged is
applied to the principal amount.
For example, if an individual takes out a $300,000
mortgage from the bank and the loan agreement
stipulates that the interest rate on the loan is 15%,
this means that the borrower will have to pay the
bank the original loan amount of $300,000 + (15% x
$300,000) = $300,000 + $45,000 = $345,000.
If a company secures a $1.5 million loan from a
lending institution that charges it 12%, the company
must repay the principal $1.5 million + (12% x $1.5
million) = $1.5 million + $180,000 = $1.68 million.

Simple Interest Rate. The examples above are

calculated based on the annual simple interest
formula, which is:
Borrower's Cost of Debt
While interest rates represent interest income to the
lender, they constitute a cost of debt to the
borrower. Companies weigh the cost of borrowing
against the cost of equity, such as dividend
payments, to determine which source of funding
will be the least expensive. Since most companies
fund their capital by either taking on debt and/or
issuing equity, the cost of the capital is evaluated to
achieve an optimal capital structure.
Interest Rate Drivers
The interest rate charged by banks is determined by
a number of factors, such as the state of the
economy. A country's central bank sets the interest
rate, which each bank use to determine the APR
range they offer. When the central bank sets interest
rates at a high level, the cost of debt rises. When
the cost of debt is high, it discourages people from
borrowing and slows consumer demand. Also,
interest rates tend to rise with inflation.
To combat inflation
1. Banks may set higher reserve requirements
2.Tight money supply ensues or
3. there is greater demand for credit
In a high-interest rate economy, people resort to saving their money
since they receive more from the savings rate. The stock market
suffers since investors would rather take advantage of the higher
rate from savings than invest in the stock market with lower returns.
Businesses also have limited access to capital funding through debt,
which leads to economic contraction.
Economies are often stimulated during periods of low-
interest rates because borrowers have access to loans at
inexpensive rates. Since interest rates on savings are low,
businesses and individuals are more likely to spend and
purchase riskier investment vehicles such as stocks. This
spending fuels the economy and provides an injection to capital
markets leading to economic expansion. While governments
prefer lower interest rates, a reason why the U.K. may never
switch to the euro, they eventually lead to market
disequilibrium where demand exceeds supply causing
inflation. When inflation occurs, interest rates increase, which
may relate to Walras' law.
 Money Demand and Money
Velocity

An economy works best when inflation is low and predictable,

but to control inflation, one needs to understand what causes it.
Over the long run, inflation is largely determined by how much
the money supply increases over increases in real GDP. In the
short run, inflation also depends on the velocity of money, which
inversely depends on the demand for money. This can be seen
from the equation of exchange
M × V = P × Y = Nominal GDP
M = Quantity of Money
V = Velocity of Money
P = Nominal Price
Y = Real GDP
Therefore:
Likewise, price changes are caused by
changes in these factors:

So, in the short term, the supply of

money and the real GDP are considered
constant, so changes in price result from
changes in the velocity of money:

ΔP = ΔV
Demand for MoneyEverybody wants money. But when economists and bankers
talk about the demand for money, they are not talking about
the demand for wealth. Instead, they are talking about how
much individuals and firms want to be liquid, how much
money they want to hold for future purchases or investments.
Liquidity is the ability to make payments, which equals the
amount of cash being held by individuals or firms plus any
assets that can easily be converted to cash for little or no fees
and with no loss of value. Thus, the demand for money can
also be called a liquidity preference. However, when
discussing the demand for money, economists and bankers
are talking about MZM money (money of zero maturity). -> It
represents all money that is readily available or in a liquid
state.
The Federal Reserve defines 3 major classes of money.
1. M1 money consists of cash in the form of currency and coins
traveler's checks, demand deposits, and checkable deposits.
2. M2 money consists of M1 plus savings deposits, certificates of
deposit of less than $100,000, and
3. Money market deposits
Because technology has blurred the distinction between M1 and M2
money in terms of liquidity, a new category of money has been
created to reflect the increased liquidity of most types of M2 money.
MZM money, which is money with zero maturity, consists of currency
and coins plus all financial assets that are redeemable at par on
demand, including traveler's checks, demand deposits, other
checkable deposits, savings deposits, all money market funds, but not
time deposits. In other words, MZM money is M2 money minus time
deposits.
The demand for money is the proportion of one's wealth
that is held as a means of payment or as assets that can
easily, inexpensively, and with little risk of loss of value
easily be converted into a means of payment. Even
though money held in savings accounts or in money
market funds earns some interest, in this context, they
are not considered investments, because they do not
earn much interest, and there's little risk for loss. People
use these accounts to earn some interest while
maintaining liquidity, thus satisfying the demand for
money.
For instance, it is often advised to save at least 6 months
of living expenses, in cases of emergencies or a job loss.
Such savings would probably be held in a savings account
or a money market fund, because it can quickly be
converted into a means of payment without incurring
transaction fees and with little risk. On the other hand,
the amount of money invested in bonds or stocks does
not satisfy the demand for money, because, although
they can quickly be sold for cash, the sale incurs
transaction costs, but more importantly, they may be sold
at a loss, if the money is needed at a certain time.
The Demand for Money and the Velocity of Money
Are Inversely Related
Over the long-term, the link between money growth and
inflation is strong, but money velocity is not constant
over the short term, so some short-term inflation may
be caused by an increase in money velocity. Although
the velocity of money cannot be measured directly nor is
it predictable over the short term, it is determined by both
the demand for money and the supply quantity of money.
An increased money supply will lower money velocity,
while a decreased money supply will increase money
velocity, all else being equal. But, in the short term, the
money supply is considered constant.
The velocity of money is the frequency that one unit
of currency is used to purchase domestically produced
goods and services within a given duration, i.e., the
number of times a dollar bill is spent to buy final goods
and services per unit of time. (To avoid double
counting, economists only measure the prices of final
goods and services, since the prices of intermediate
products and services are included in the final prices.)
By definition, money velocity increases when money
is spent more frequently for final goods and services
per unit of time. Additionally, money velocity can be
increased indirectly by increased investments.
Although an investment is not a purchase of a final
good or service, it does stimulate such purchases by
lowering the interest rate, since it is well-established
that — all else being equal — lower interest rates
stimulate aggregate demand, which is the total
demand for all goods and services produced by an
economy.
How increased investments can reduce the interest
rate can best be illustrated with bonds. Because bond
yields are inversely proportional to bond prices, an
increased demand for bonds will raise their prices, thus
lowering their yields. This means that companies can
issue bonds at lower yields, which decreases their
demand for loanable funds, thereby propagating the
decrease in interest rates throughout the economy.
Likewise, purchases of stock can also lower general
interest rates, because companies that obtain funding
by issuing stock will have a lower demand to borrow
money.
Hence, a lower demand for money increases money
velocity in 2 ways:
1. An increase in spending and/or an increase in
investments. Likewise, higher demand for money will
decrease spending and/or investments, which
decreases the velocity of money. Therefore, any
factors that cause people to hold money will
decrease the velocity of money, while factors that
increase spending or investment will increase the
velocity of money. Therefore, the demand for money
is inversely related to the velocity of money. To
understand how the velocity of money changes, one
must understand what changes the demand for
Under most economic models, over the long-term,
inflation depends on how much the growth of the
money stock exceeds real GDP. The supply of money
is the only factor that politicians can control, at
least directly. Real GDP and the velocity of money
cannot be controlled legally or politically.

So to control inflation by targeting the money growth

rate, a central bank must know what influences the
demand for money and how changes in monetary
policy rules will influence that demand.
The Effect of Lower Interest Rates Will Depend on Debt
Load and Economic Conditions
The increase in aggregate demand with lower interest
rates will depend on the debt load of consumers and firms
and on economic conditions. While lower interest rates do
stimulate aggregate demand, with all else being equal, the
magnitude of this effect will depend on debt loads and
economic conditions. High debt loads will decrease the
stimulatory effect of lower interest rates, because debtors
will be reluctant or unable to increase their debt load.
Furthermore, they must decrease spending and
investments to pay their debt. Likewise, when economic
conditions are poor, consumers and firms will be reluctant
to increase spending or to increase investments, because
of the increased risk.
This is best illustrated by the prolonged period for the
economy to emerge from the Great Recession of 2007 to
2009, despite record low interest rates. Consumers and
firms were deeply in debt, so their creditworthiness had
declined dramatically. Additionally, because banks wanted
to avoid more losses, their lending requirements became
stricter. Few people could take out loans, even if they
wanted to. Furthermore, because people didn't have
money to spend, firms were also unwilling to borrow,
since they already had excess capacity due to their
depressed economy. So, at the start of the Great
Recession, lower interest rates had a much lesser
effect in stimulating the economy, which is why the
after effects of the recession lasted so long.
 DETERMINANTS OF THE DEMAND FOR
MONEY
The primary factors affecting the demand for money are
the:
1. inflation rate
2. price levels
3. nominal interest rates
nominal income
4.

5. real GDP
6. transfer costs
7. faster transfers
8. preferences, and
9. technology.
Inflation may increase or decrease the velocity of money,
depending on which factors are more prominent. Low
inflation increases demand for money because higher prices
requires more money for a given amount of goods and
services. But higher inflation also increases the holding costs
of money. For instance, if the inflation rate is 10%, then the
cost of holding money is -10%. So when inflation is high,
people will either spend it or invest it before the money
loses value. This is particularly true in hyperinflation
environments. Hence, higher inflation rates increases the
velocity of money, which increases inflation even more. As
with inflation, higher price levels will also increase the demand
for money.
Because money is used as a means of payment, a higher nominal
income tends to increase the amount of money people desire to
hold, since wealthier people buy more expensive products and
services and have a higher level of expenditures. Because incomes
increase with real GDP, the demand for money will also
increase with increases in the real GDP.

Higher interest rates reduces the demand for money by increasing

the opportunity cost of holding money, which is the interest that
could be earned if the money was invested. So if the interest rate is
5%, then the cost of holding money is the 5% that could have been
earned in interest. Expectations of a higher interest rate will
increase the demand for money, since interest-paying securities
decline in price when interest rates rise.
Preferences may also change with economic conditions.
When the economy is good, people tend to hold less
money by spending more or investing more. When the
economy is declining, people feel more anxious, which
increases their demand for money. This is sometimes
called a precautionary demand for money, which is
money held for emergency expenses. Since people with
higher incomes generally have higher expenses, they
tend to hold more money for emergencies. The
precautionary demand for money will also be greater
with greater uncertainty about the future. For instance,
if you feel insecure about your job, you will tend to hold
more money because of increased unemployment risk.
Technology that provides liquidity, such as
credit cards, reduces the demand for money,
since these payment substitutes provide a
means of payment without the need to hold
money. Likewise, lower transfer costs and
faster transfers between accounts will
lower the demand for money.
 The demand for money is
inversely related to interest rate.
 TRANSACTIONS AND PORTFOLIO DEMAND FOR
MONEY
Money can be spent or invested, so the desire to hold money is to
make a future purchase or investment rather than buying or
investing now. The main benefit of holding money is that it
provides the holder flexibility.

Distinction between the transactions demand for money and

the portfolio demand for money.
-The transactions demand for money is the demand for money
intended to be used for a future purchase.
-The portfolio demand for money is money held for future
investments.
The portfolio demand for money increases with wealth and
portfolio risk and decreases with increased portfolio returns, lower
risk, or lower opportunity costs. In other words, the portfolio
demand for money is influenced by the same factors that
influence the demand for bonds. People with greater wealth
want to invest more, since they have most of the goods and
services that they want, while higher investment risks will cause
people to invest less, since there is a greater chance for loss. By
contrast, greater portfolio returns and reduced risk decreases
the demand for money, since there is an opportunity cost of not
investing, and vice versa.
For instance, when bonds pay 2% interest or less, people tend to
hold more money in their checking accounts, because it is more
liquid and the opportunity cost of earning interest from bonds is
low. Additionally, the risk from bonds is low, but not 0, so a low
interest rate may not compensate for the risk. If interest rates
are high and risks are low, then people will want to invest
more. If interest rates are expected to rise in the future, then
people will hold more money, because rising interest rates causes
the value of bonds and other interest-paying financial instruments
to fall in value. Stocks also tend to decline with higher interest
rates.
 CENTRAL BANKS TARGET INTEREST RATES RATHER THAN
MONEY GROWTH TO CONTROL SHORT-TERM INFLATION
Since the factors that influence the demand for money are difficult
to measure directly, central banks use statistics to predict how
changes in monetary policy will affect the demand for money.
Nonetheless, because the demand for money and, therefore, the
velocity of money, fluctuates considerably over the short term,
the link between money supply and inflation is weak over the
short term. Hence, by targeting money growth, interest rates
fluctuate with the velocity of money. Because a stable interest rate
helps to stabilize the economy, but money growth causes
interest rates to fluctuate, central banks target interest rates
rather than money growth as a means to control short-term
 Various forms of interest, and how each might impact consumers
seeking credit or a loan.

1. Fixed Interest
A fixed interest rate is as exactly as it sounds - a specific, fixed
interest tied to a loan or a line of credit that must be repaid,
along with the principal. A fixed rate is the most common form
of interest for consumers, as they are easy to calculate, easy to
understand, and stable - both the borrower and the lender
know exactly what interest rate obligations are tied to a loan or
credit account.
For example, consider a loan of $10,000 from a bank to a
borrower. Given a fixed interest rate of 5%, the actual cost of
the loan, with principal and interest combined, is $10,500.This
is the amount that must be paid back by the borrower.
2. Variable Interest
Interest rates can fluctuate, too, and that's exactly what
can happen with variable interest rates.

Variable interest is usually tied to the ongoing movement

of base interest rates (like the so-called "prime interest
rate" that lenders use to set their interest rates.)
Borrowers can benefit if a loan is set up using variable
rates, and the prime interest rate declines (usually in
tougher economic times.)That said, if base interest rates
rise, then the variable rate loan borrower may be forced
to pay more interest, as loan interest rates rise when
they're tied to the prime interest rate.
Banks do this to protect themselves from interest rates
getting too out of whack, to the point where the
borrower may be paying less than the market value for
interest on a loan or credit.

Conversely, borrowers gain an advantage, too. If the

prime rate goes down after they're approved for
credit or a loan, they won't have to overpay for a
loan with a variable rate that's tied to the prime
interest rate.
3. Annual Percentage Rate (APR)

The annual percentage rate is the amount of your total

interest expressed annually on the total cost of the
loan. Credit card companies often use APR to set
interest rates when consumers agree to carry a
balance on their credit card account. APR is
calculated fairly simply - it's the prime rate plus the
margin the bank or lender charges the consumer. The
result is the annual percentage rate.
4. The Prime Rate

The prime rate is the interest that banks often give

favored customers for loans, as it tends to be relatively
lower than the usual interest rate offered to customers.
The prime rate is tied to the U.S. federal funds rate, i.e.,
the rate banks turn to when borrowing and lending
cash to each other. Even though Main Street Americans
don't usually get the prime interest rate deal when they
borrow for a mortgage loan, auto loan, or personal
loan, the rates banks do charge for those loans are tied
to the prime rate.
5. The Discount Rate

The discount rate is usually walled off from the general

public - it's the interest rate the U.S. Federal Reserve
uses to lend money to financial institutions for short-
term periods (even as short as one day or
overnight.)Banks lean on the discount rate to cover
daily funding shortages, to correct liquidity issues, or in
a genuine crisis, keep a bank from failing.
6. Simple Interest

The term simple interest is a rate banks commonly use to

calculate the interest rate they charge borrowers
(compound interest is the other common form of interest
rate calculation used by lenders.)Like APR, the calculation for
simple interest is basic in structure. Here's the calculus
banks use when determining simple interest:

Principal x interest rate x n = interest

For example, let's say you deposited $5,000 into a money
market account that paid a 1.5% for three years.
Consequently, the interest the bank saver would earn over
the three- year period would be $450 < x .03 x 3 = $450.>
7. Compound Interest

Banks often use compound interest to calculate bank rates.

In essence, compound rates are calculated on the two key
components of a loan - principal and interest. With
compound interest, the loan interest is calculated on an
annual basis. Lenders include that interest amount to the
loan balance, and use that amount in calculating the next
year's interest payments on a loan, or what accountants call
"interest on the interest" of a loan or credit account balance.
Use this calculus to determine the compound interest going
forward:
Here's how you would calculate compound interest:
-Principal times interest equals interest for the first year of a
loan.
-Principal plus interest earned equals the interest for the
second year of a loan.
-Principal plus interest earned times interest equal interest
for year three.
The key difference between simple interest and compound
interest is time. Let's say you invested $10,000 at 4% interest
in a bank money market account. After your first year, you'll
earn $400 based on the simple interest calculation model. At
the end of the second year, you'll also earn $400 on the
investment, and so on and so on.
With compound interest, you'll also earn the $400 you
receive after the first year - the same as you would under
the simple interest model. But after that, the rate of interest
earned rises on a year-to-year basis.

For example, using the same $10,000 invested at a 4%

return rate, you earn $400 the first year, giving you a total
account value of $10,400. Total interest going forward for
the second year isn't based on the original $10,000, now it's
based on the total value of the account - or $10,400.
Each year, the 4% interest kicks in on the added principal
and grows on a compound basis, year after year after
year. That gives you more bang for your investment buck
than if the investment was calculated using simple
interest.
The Takeaway

Whether you're a borrower looking for a better deal on a

home loan or credit card, or you're an investor looking for
a higher rate of return on an investment, getting to know
interest rates, and how they work is vital to maximizing
loan and investment opportunities. One day, you may
need to make a big decision on one of them, with your
money on the line.
 Source:
Investopedia,
www.thismatter.com
Banking and Finance,
END www.thestreet.com