*interest rates*

**Interest**is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds.

An

**interest rate**is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor). Specifically, the interest rate (I/m) is a*percent of principal*(P) paid a certain amount of times (m) per period (usually quoted per annum). For example, a small company borrows capital from a bank to buy new assets for its business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest rates are normally expressed as a percentage of the principal for a period of one year*REASONS WHY INTEREST RATES CHANGES*

**Political short-term gain**: Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on 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 he chooses one, he 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, die, 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 to realize.**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.

**Types of Interest Available for Business Loans**

Few
businesses are able to make major purchases without taking out loans.
Businesses must pay

*interest,*a percentage of the amount loaned, to whoever loans them the money, whether loans are for vehicles, buildings, or other business needs.
Some
businesses loan their own money and receive interest payments as income. In
fact, a savings account can be considered a type of loan because by placing
your money in the account, you’re giving the bank the opportunity to loan that
money to others. So the bank pays you for the use of your money by paying
interest, which is a type of income for your company.

The
financial institution that has your money will likely combine your money with
that of other depositors and loan it out to other people to make more interest
than it’s paying you. That’s why when the interest rates you have to pay on
loans are low, the interest rates you can earn on savings are even lower.

Banks
actually use two types of interest calculations:

·

**Simple interest**is calculated only on the principal amount of the loan.
·

**Compound interest**is calculated on the principal and on interest earned.**Simple interest**

Simple
interest is simple to calculate. Here’s the formula for calculating simple
interest:

*Principal × interest rate ×*

**n**= interest
To
show you how interest is calculated, assume that someone deposited $10,000 in
the bank in a money market account earning 3 percent (0.03) interest for 3
years. So, the interest earned over 3 years is $10,000 × .03 × 3 = $900.

**Compound interest**

Compound
interest is computed on both the principal and any interest earned. You must
calculate the interest each year and add it to the balance before you can
calculate the next year’s interest payment, which will be based on both the
principal and interest earned.

Here’s
how you would calculate compound interest:

*Principal × interest rate = interest for Year One*

*(Principal + interest earned) × interest rate = interest for Year Two*

*(Principal + interest earned) × interest rate = interest for Year Three*

You
repeat this calculation for all years of the deposit or loan. The one exception
could be with a loan. If you pay the total interest due each month or year
(depending on when your payments are due), there would be no interest to
compound.

When
working with large sums or high interest rates for long periods of time,
compound interest can make a big difference in how much you earn or how much
you pay on a loan.

Ideally,
you want to find a savings account, certificate deposit, or other savings
instrument that earns compound interest. But, if you want to borrow money, look
for a simple interest loan.

Not
all accounts that earn compound interest are created equally. Watch carefully
to see how frequently the interest is compounded. If you can find an account
where interest is compounded monthly, the interest you earn will be even
higher.

Monthly
compounding means that interest earned will be calculated each month and added
to the principle each month before calculating the next month’s interest, which
results in a lot more interest than a bank that compounds interest just once a
year.

**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 are sometimes complicated. However, economists generally
agree that the interest rates yielded by any investment take into account:

- The
risk-free cost of capital
- Inflationary
expectations
- The level
of risk in the investment
- The costs
of the transaction

This rate
incorporates the

*deferred consumption*and*alternative investments*elements of interest**Real vs nominal interest rates**

*Further information: Fisher equation*

The

__nominal interest rate__is the amount, in percentage 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.
If inflation in
the economy has been 10% in the year, then the $110 in the account at the end
of the year buys the same amount as the $100 did a year ago. The

__real interest rate__, in this case, is zero.
After the fact,
the 'realized' real interest rate, which has actually occurred, is given by the

__Fisher equation__,