Interest rate
Family IX · Macro
Not to be confused with exchange rate, floating exchange rate, inflation rate.
Interest rate is the cost of borrowing money or the return on lending it, expressed as a percentage of the principal per period. It is a core macroeconomic variable that influences saving, investment, borrowing costs, and the general level of economic activity. Rates are quoted in different ways, such as nominal or real, simple or compound, and fixed or variable.[1]
Types and Variations
Interest rates vary by borrower, term, currency, and jurisdiction. Common distinctions include:
- Nominal vs. real: The nominal rate is the stated rate; the real rate adjusts for inflation.
- Simple vs. compound: Simple interest is calculated only on the principal; compound interest is calculated on principal plus accumulated interest.
- Fixed vs. variable: A fixed rate remains constant; a variable rate changes with a reference rate such as a central bank policy rate or an interbank offered rate.
Central banks set policy rates that influence other rates in the economy, but the exact pass-through and the level of rates differ across countries and over time.
Worked Example
Suppose a loan of 10,000 units at a nominal annual interest rate of 5%, compounded annually, for 3 years. The future value is calculated as:
The total interest paid over three years is 1,576.25 units.
Related Concepts
Interest rates are distinct from other economic rates. For example, the exchange rate is the price of one currency in terms of another. A floating exchange rate is determined by market forces. The inflation rate measures the percentage change in the general price level. While these concepts interact—for instance, interest rate differentials can influence exchange rates—they represent different economic phenomena.
Often confused with
- exchange rate
- The exchange rate is the price of one currency expressed in another currency, not the cost of borrowing money; it is quoted as a currency pair such as EUR/USD.
- floating exchange rate
- A floating exchange rate is a currency regime where the exchange rate is determined by supply and demand in the foreign exchange market, not a percentage charged on loans; it is identified by the absence of a fixed peg.
- inflation rate
- The inflation rate measures the percentage change in the general price level over time, not the cost of borrowing; it is typically reported as an annual percentage change in a price index such as the CPI.
See also
References
- ↑ Policy rate publications of the relevant central banks. Overnight financing follows the interest-rate differential between the two currencies, plus the broker's own markup, so the figure is not fixed.