Money and Interest Rates

    Our modern financial system consists of currency (notes and coins), cheques, automated teller machines, and numerous sophisticated financial instruments with different degrees of liquidity. However, money still occupies a central place in any financial system.

What is Money?

    Anything which is commonly and universally accepted as a medium of exchange or means of payment is called money. Before money was introduced commodities were directly exchanged for commodities. This was known as the barter system. But the barter system created various problems and money was introduced to solve these problems. In a modern economy, called a monetary economy, commodities are first sold for money and then the money is again used to buy other commodities. Money as a medium of exchange first came into existence in the form of commodities like wine, copper, iron, gold, diamonds, or even cattle. These forms of money had intrinsic value, meaning that they had value in themselves. The age of commodity, which lasted for quite a long-time, yielded place to paper money. It is a convenient medium of exchange. It has value due to limited supply today in the age of bank money cheques written on funds deposited in a bank or any other financial organization. Nowadays cheques are accepted in place of cash payment for many, goods and services. In fact, most transactions now take place through bank money and only a small portion by currency.

    Today, we find extremely rapid innovation in the different forms of money. Now credit cards and traveler’s cheques are often used for various transactions. However, such fast-changing nature of money makes it difficult for the Central Bank to smoothly conduct its monetary policy (whose basic objective is to control the nation’s money supply).

Components of the Money Supply:

    The concepts and definitions of money supply differ from country to country and period to period. Two widely used definitions of the money supply are transactions money (M1) and broad money (M2).

While M consists of currency and bank deposits withdrawable by cheques (called narrow money), M2 adds to these certain money substitutes or near-money assets such as fixed deposits, life insurance policies, national saving certificates, and so on (called broad money).

The last few assets are no doubt as liquid as money but they are not money in the true sense because they are not accepted in day-to-day transactions.

The four components of money supply are the following:

M1 = currency with the public, i.e., notes + coins + demand deposits (withdrawable by cheques) of the public, known as narrow money.

M2 = M1 + post office savings deposits.

M3 = M2 +Time (fixed) deposits of the public with banks, known as broad money.

M4 = M3 + total post office deposits.

Interest Rates

        Like all other commodities, money has also a price. And the price of money is the rate of interest. It is the periodic payment made for the use of money. The cost of borrowing money, measured in rupees per year per rupee borrowed, is the interest rate. Interest is the charge made to the borrower by the lender for the use of money, expressed in terms of an annual rate of percentage upon the principal. In other words, the interest rate is a percent of the principal or an amount borrowed or lent, expressed as the ratio of the amount of interest paid or earned, during a certain period of time, to the amount of principal. The rate of interest measures the percentage reward a lender receives for deferring the consumption of resources until a future date. Correspondingly, it measures the price a borrower pays to have resources now. Interest is the additional payment, called the interest rate, on top of the principal paid to a lender for the right to borrow money. The interest rate is expressed as an annual percentage rate, and the payment could be a fixed amount of money (fixed rate) or rates paid on a sliding scale (known as a variable payment. Basically, interest is the toll you pay to travel on the credit highway, at a specific price and for a specific period of time.

An Array of Rates

    In traditional economic theory, it is assumed ‘the’ rate of interest: but in today’s complex financial system it comes across a vast array of interest rates. Interest rates differ mainly due to differences in the characteristics of the loan or of the borrower.

The main differences are the following

Ø  Term or Maturity

    Loans differ in their maturity the length of time until they are repaid. Short-term loans are usually made for periods up to one year. Long-term loans which have maturities of 5 to 10 years usually command higher rates of interest. The reason is easy to find out. People will be ready to sacrifice their liquidity for a long period of time if and only if they get a higher return.

Ø  Risk

    Loans made for certain purposes (e.g., speculation) are riskier than loans made for other purposes (e.g., transport business or house construction). Those who lend money in risky ventures usually expected higher returns than those who make comparatively safe loans. The safest loans are the bonds of the government (called gilt-edged securities which are free from default). This is why those who buy government bonds get less interest than those who prefer to buy risky private bonds or debentures. Slightly risky loans are borrowings of creditworthy corporations. Highly risky investments, which bear a significant chance of default or non-payment, include those in companies close to bankruptcy.

Ø  Liquidity

    Any asset which can easily be converted into cash with little, if any, loss of value is called a ‘liquid’ asset. Most marketable securities, including corporate and government bonds, are highly liquid assets because they may quickly be turned into cash for close to their current value. Illiquid assets are those which cannot be sold easily and quickly in the market at a fair price.

An example of such an asset is a losing private company or a house located in a backward region. Such illiquid assets or loans usually command considerably higher interest rates than do liquid, risk-less ones because of the higher risk and the difficulty of extracting the borrower’s investment.

Why Interest is Paid or Charged

There are two views regarding Interest paid or is charged:

(i) From Debtor’s point of view,

(ii) From the Creditor’s point of view.

Ø  From Debtor’s Point of View:

    Debtors pay interest on capital because he is aware that capital has productivity and if it can be used in production there can be an increase in income. Therefore, out of the earned income, a part of the income is paid to the creditor or a lender from whom money has been taken as a loan is known as Interest.

Following are the important reasons for giving Interest:

Ø  Use of Capital:

    Whatever amount is paid to the owner of the capital for the use of the capital is known as Interest. Here, the capital is used in further production and whatever he earns, he pays a part of his earnings to the owner of the capital or the lender of the money.

Ø  Reward for Risk:

    Loan giving is a risk that a lender takes at the time of giving a loan or advancing money. The lender exposes himself to risk when he lends money and sometimes the loan becomes bad debt. Therefore, it has been said that Interest is the reward for risk-taking.

Ø  Interest is Reward for Inconvenience:

    When a lender gives a loan of money he forgets its use for the duration of the loan, if he needs this amount for his personal use, he will have to undergo the inconvenience of arranging it from some other source. Thus, he feels inconvenienced.

Ø  Expenses in Relation to Management of Business:

    For organizing and running the business, a businessman needs money. Money was taken as a loan for running and managing the business, keeping accounts, maintaining the standard of business, etc. one has to arrange money and for that has to pay interest over the money.

Ø  From Creditor’s Point of View:

Creditors or lenders of money demands Interest because he has taken pains in saving money, has suffered inconveniences in postponing his needs, and has taken risk of bad debts. If he will not get Interested or some advantage of Interest he may lose interest in saving money or he may not be ready to bear inconveniences. Then, the formation of capital in the market will stop. Therefore, it can be said that the debtors give Interest to creditors as capital has productivity and creditors demand interest as the lender of money has taken the risk and has faced inconveniences, so he must get some reward for the pains of inconvenience and risk.


Know these five keys about interest when you're applying for credit or taking out a loan:

·         The amount of interest paid depends on the terms of the loan, worked out between the lender and the borrower.

·         Interest represents the price you pay for taking out a loan - you still have to pay off the base principal of the loan, too.

·         Interest on loans is usually pegged to current banking interest rates.

·         Your interest rate on a credit card, auto loan, or another form of interest can also depend largely on your credit score.

·         In certain cases, like with credit cards, your interest rate can rise if you're late on a payment, or don't make a payment.

If you dig down into the interesting landscape, you'll see that there are multiple forms of interest that may confront a borrower. Thus, it's in the best interest of a borrower to get to know the various types of interest and how each may impact the acquisition of credit or a loan. After all, the more knowledge gained from better understanding interest, and how it works in all of its forms, can be leveraged to get you a better deal the next time you apply for a loan or a credit account.

Types of Interest Rate

Basically, there are six types of interest rate which are as follow

1.      Fixed Interest Rate

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. 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.

4.      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.


5.      Simple Interest

The term simple interest is a rated bank commonly used 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 are 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 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.>.

6.      Compound 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 time’s 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.

Types of Interest Rate for payment

There are two types of Interest:

(a) Net Interest,

(b) Gross Interest.

(a) Net Interest:

The payment made exclusively for the use of capital is regarded as net Interest or pure Interest. According to Prof. Chapman “Net Interest is the payment for the loan of capital when no risk, no inconveniences apart from that involved in saving and no work is entailed on the lender.” According to Prof. Marshall, “Net Interest is the earnings of capital simply or the reward of waiting simply.”

Thus, Net Interest = Gross Interest – (payment for risk + payment for inconvenience + cost of administering credit).

i.e., Net Interest = Net Payment for the use of capital.

(b) Gross Interest:

Gross Interest according to Briggs and Jordan has said: “Gross Interest is the payment made by the borrowers to the lenders is called Gross Interest or Composite Interest.”

It includes payments for the loan of capital payment to cover risks for loss which may be:

(i) personal risks or (ii) Business risks, payment for inconveniences of the investment and payment for the work and worry involved in watching investments, calling them in, and investing.

Gross Interest = Net Interest + payment of risk + payment for inconvenience + cost of administrating credit.

Elements of Gross Interest:

As it has been discussed earlier that the actual amount paid by the borrower to the capitalist as the price of capital fund borrowed is called gross interest.

Ø  Payment or Compensation for Risk:

The lender has always to bear the risk—the risk that the loan may not be repaid. Besides this, borrower, takes the loan at the time when his requirement is urgent but when he returns it, it is quite possible that the time may not be suitable from the lender’s point of view. To cover this risk, the lender charges more, in addition to the net interest. Thus, when loans are made without adequate security, they involve high elements of risk, so a high rate of interest is charged.

Ø  Compensation for Inconvenience:

When somebody lends the money, he has to bear inconveniences till the period when he gets back the sum, i.e., a lender lends only by saving that is by restricting consumption out of his income which obviously involved some inconveniences which is to be compensated. A similar inconvenience is that the lender may be able to get his money back as and when he may need it for his own use. Hence, payment to compensate for this sort of inconvenience may be charged by the lender. Thus, the greater the degree of inconvenience caused to the lender, the higher will be the rate of Interest charged.

Ø  Cost of Administering the Credit or Payment for Management Services:

A lender of capital funds has to spend money and energy in the management of credit.

For example: In the lending business, certain legal formalities have to be fulfilled, say fees for obtaining money-lender’s license, stamp duties, etc. Proper accounts must be maintained. He has to maintain a staff as well. For all these sorts of management services reward has to be paid by the borrower to the lender. Therefore, gross interest also includes payment for management expenses.

Ø  Compensation for the Changing Value of Money:

Under this when prices are rising, the purchasing power of money declines over a period of time and the creditor loses. To avoid such loss and high rate of Interest may be demanded by the lender.

Therefore, Gross Interest = Net Interest + Payment for risk + Payment for management services + Compensation for the changing value of money. In economic equilibrium, the demand and supply for capital determine the net rate of interest. But in practice, the gross interest rate is charged. Gross interest rates are different in different cases at different places and at different times and for different individuals.

Factors Influencing the Rate of Interest

Ø  Different Types of Borrowers:

There are different types of borrowers in the market. They offer different types of securities. Their borrowing motives and urgency are different. Thus, the risk elements differ in different cases, which have to be compensated for.

Ø  Due to Differences in Gross Interest:

Variations in the rate of Interest are due to differences in gross interest such as risk and inconveniences involved, cost of keeping records and accounts and collection of loans etc. The greater the risk and inconvenience and the cost of management of loans, the higher will be the rate of Interest and vice-versa.

Ø  The Money Market is not homogeneous:

There are different types of lenders and institutions, specializing in different types of loans and the loan-able funds are not freely mobile between them. The ideals of these institutions are also different. Again, there are money lenders and indigenous bankers in the unorganized sector of the money market who follow their distinct lending policies and charge different interest rates.

Ø  Duration of Loan or Period of Loan:

The rate of Interest also depends upon the duration or period of the loan. Larger term loans carry a higher rate of Interest than short-term loans. In a long-term loan, the money gets locked up for a longer duration. Naturally, the lender wants to be compensated by a higher rate of interest.

Ø  Nature of Security:

The interest rate varies with the type of security. Loans against the security of gold carry fewer interest rates than loans against the security of gold carry less interest rate than loans against the security of immovable property like land or house. The more liquid is the assets the lower is the interest rate and vice-versa.

Ø  Goodwill or Credit of the Borrower:

The interest rate also depends upon the credit or goodwill of the borrower. Persons of better goodwill and known integrity and credibility can get loans on easy terms.

Ø  Interest Policy of the Monetary Authorities:

Monetary policy of the authorities may also lead to differences in Interest rates, e.g., the Reserve Bank of India has adopted differential interest rates policy for the deployment of credit to the priority sectors.

Ø  Difference Due to Distance:

Distance between the lender and the borrower also causes differences between Interest rates. People are willing to lend at a lower rate of Interest nearer home than at a long distance.

Ø  Market Imperfections:

Differences in Interest rates are also due to market imperfections that may be found in a loan market. Money-lenders indigenous banks, mutual funds, commercial banks, etc. follow different lending policies and charges various Interest rates.

Ø  Differences in Productivity:

Productivity of capital differs from work to work or from venture to venture. People are willing to borrow at a higher rate of Interest for productive purposes or productive ventures and vice-versa.

Grounds in which Payment of Interest is Justified:

The payment of Interest is justified on various grounds.

The following are the reasons for payment of Interest:

Ø  The Productivity of Capital:

Interest is paid by the borrower to the lender because borrowed money capital is productively used.

Ø  Compensation for Parting with Liquidity:

As Keynes has said that interest is the reward for parting with liquidity when a lender lends money he undergoes a sacrifice of present time consumption is parting with its purchasing power to the borrower. This is to be compensated by the borrower to the lender by paying a rate of Interest as agreed upon.

Ø  To Induce Savings:

The lending of money mostly comes out of savings. Savers are induced to save more by restricting consumption when high rates of Interest are paid. When investment demand is in excess of savings, Interest rates will go up.

Ø  To Mobilize Loan-Able Funds

Banks and other financial institutions offer Interest rates to mobilize loanable funds from the household sector to the money and capital markets. People may opt for the financial investment of their savings when attractive returns are offered by financial institutions. Financial institutions serve as intermediaries and pass on these funds so mobilized to the firm sector for real investment. Similarly, the demand for Interest on the lender’s side is also justifiable for the reason for abstinence or sacrifice of immediate consumption undergone by them in parting with liquidity. They also claim a share in the income generated by capital in its productive use in terms of Interest rate. They also face the risk of losing money when the loan is not repaid by the borrower. To compensate for all these risk elements, they reasonably demand some Interest.

The Role of the Interest Rate in the Economy

Many financial decisions involve a trade-off between present and future consumption. One example of this is households' decisions on saving and borrowing. Income from employment normally varies in the course of a lifetime. Earnings are low when people are young, rising in middle years, before falling again as they reach retirement age. Many people raise loans in early adulthood, repay their loan and build up positive net wealth as they reach middle age, then draw on their savings towards the end of their lives. This results in consumption that is more evenly spread over a lifetime than implied by the flow of annual income. A company's investment choices also involve the choice between present and future consumption. Owners may give priority to present consumption by taking out dividends, or they can invest profits in the company and thereby lay the basis for larger profits later. By placing capital at the disposal of others, in other words by saving, one's own consumption is postponed. People require compensation for this, both because human beings are impatient and because there is a certain probability we may not live to see the future. The interest rate provides this compensation. If it is desired to use the money for consumption now or to finance investments by raising loans, the interest rate is the price that must pay in order to do so. The interest rate is therefore a key variable choice between consumption now or in the future.

Ø  Interest rates are the terms at which money or goods today may be traded off for money or goods at a future date.

The interest rate is also the price of money. It may choose to store our savings in the form of cash or in a current account. The price which may pay is the return other alternatives would have provided. Bank deposits and bonds are examples of investments that provide a reliable return-interest income. If it is to choose to store money, people lose this income. But in contrast to bonds, money can be used directly to purchase goods and services. Interest is therefore also the price is to pay in order to have liquid holdings.

The interest rate is also used as an instrument in economic policy. Setting the interest rate to achieve a monetary policy objective, often price stability or low and stable inflation, is usually the responsibility of the central bank. The central bank sets a very short-term nominal interest rate.

For example; In Norway, this is the interest rate on banks' overnight deposits in Norges Bank, the sight deposit rate. This rate determines the very short interest rates in the money market with maturities from one day upwards, normally up to Norges Bank's next monetary policy meeting. Longer-term rates are determined by expectations concerning Norges Bank's use of instruments in the future and by the degree of confidence in monetary policy. The real interest rate, which is the nominal interest rate minus expected inflation, is the rate that influences decisions concerning saving and investment. The interest rate influences inflation indirectly via domestic demand for goods and services and via its effect on the exchange rate. When the interest rate falls, it is less profitable for households to save, and they will therefore increase their consumption now rather than wait until later. Borrowing also becomes less costly, with an associated rise in investment. Higher demand in turn leads to a higher rise in prices and wages. Lower interest rates make it less attractive to invest in NOK and less attractive for Norwegian. Enterprises and households to raise loans in other currencies. Lower interest rates will therefore normally result in reduced capital inflows and a weaker krone. This makes imported goods more expensive. In addition, a weaker krone increases activity, profitability and the capacity to pay in the internationally exposed sector.

The equilibrium interest rate and the neutral interest rate are closely related concepts.

The neutral interest rate is the rate that does not in itself result in an increase or a reduction in price and cost inflation in the economy in the course of a business cycle. An assessment of whether interest rate setting is expansionary or contractionary involves comparing short-term market rates with the neutral rate. A real interest rate in the interval 3 - 4 percent is often regarded as neutral in economies. In the longer term, the interest rate level influences capital accumulation in the economy and the potential for economic growth. The equilibrium interest rate is the rate that ensures that capital accumulation corresponds to saving in the economy. This results in an output potential that over time satisfies demand without generating pressures in the economy.

The equilibrium interest rate is determined by long-term phenomena associated with the structure of the economy, while the neutral rate is defined on the basis of its influence on pressures in the economy and thereby on inflation. In the long term, the neutral interest rate will correspond to the long-term equilibrium interest rate in the economy. The long-term equilibrium interest rate is determined by fundamental structural relationships in the economy, such as consumer impatience and the economic growth rate. Rising population growth means that a larger labor force must be equipped with real capital. Fixed investment and saving must increase. Higher population growth will therefore require a higher equilibrium interest rate. The higher productivity growth is, the higher future gains from today's investments will be. This also provides the basis for a higher equilibrium interest rate.

The long-term equilibrium interest rate cannot deviate too much between countries over time. With liberalized capital markets, capital will move towards those countries that can provide the highest return. Substantial interest rate differentials between countries cause fluctuations in the exchange rate and will not be compatible with a long-term equilibrium. Thus, we may refer to a global equilibrium interest rate for open economies, although perhaps with an added national risk premium. The interest rate has thus several roles to play in the economy and these roles should be fairly closely linked. The interest rate shall in the short and medium-term contribute to stable inflation and stable developments in production. At the same time, it shall in the long term also contribute to equilibrium in the market for real capital. Capital accumulation shall over time correspond to saving. To achieve this, the real interest rate must not over time deviate substantially from the return on real capital. Substantial deviation scans give rise to undesirable fluctuations in the markets for real capital that have no basis in economic fundamentals. The economic situation varies over time. Monetary policy will set an interest rate that is alternately above and below the neutral rate. Consequently, the interest rate level will probably not deviate substantially from the long-term equilibrium rate over time. By taking a gradualist approach to interest rate setting, it is also possible to assess whether imbalances are developing in capital markets.

By: Sumiya Dost

The writer is a Post-graduate student from the Economics Department University of Turbat

Turbat Kech Balochistan