In a loan structure whatsoever, the interest rate is the difference (in percentage) between money paid back and money got earlier, keeping into account the amount of time that elapsed. If you were given 100$ and you give back 120$ after a year, the interest rate you paid was 20% a year.
Nominal interest rate are laid down in contracts between involved parties. Real interest rates somehow adjust the nominal ones to keep inflation into account. For instance if inflation was 15%, in the previous example the real interest rate can be said to be 20%-15% = 5%, in a simplified way of computation.
Interest rate paid in actual transactions should not be mistaken for the subjective inner computational tool expressing patience or impatience and the balance between present and future flows, which is called "discount rate" in investment decisions, which in turn can be influenced by the cost of capital, both internal and external, but remains rooted in the actor's identity, history, and interpretation of business cycle and long-term trends.
the institution offering the credit;
For instance, the fixed interest rate paid to a bank by private firms for financing an industrial investment, characterized by a payback period of 3-7 years, exerts a crucial importance in the economy. In fact, it may influence overall investment, thus the business cycle.
As the typical lending institution, the bank finances its credit activity in several ways:
1. by collecting money from households deposits (and pay to them an interest rate on deposits),
2. by issuing its own obligations, characterised by a bonds interest rate,
3. by taking short-term loans from other banks, paying the interbanking interest rate,
4. by borrowing money from the central bank, which requires an interest rate for refinancing operations.
the interest rate to the public, banks all over the world make reference
to these rates (e.g. "1.5% more than EURIBOR" - the famous interbank
interest rate for loans in euros).
If the firm is a sound primary firm with excellent trustworthiness, the bank would agree an interest rate only slightly higher than the rate the same bank would be requested to pay in the interbanking market from other lending institutions. By contrast, for smaller industrial firms, the rate usually would be significantly higher because of the worsened credit risk.
Apart from bank loans,
a key interest rate in the economy is that paid on Treasury bonds.
Similarly, private, public and state-owned firms issue bonds as
well, expressing further nominal interest rates.
Both state and firm
bonds can be continously exchanged in public markets, making their
effective interest rate dependent on the price at which
it has been bought. A bond, whose nominal price is 100 and interest rate
is 5%, will in reality give a 10% yield if it is bought at a price of
50 in the public market.
pay an interest when taking loans for consumption purposes.
The following picture summarizes most of what we said, with an arrow for each kind of interest rate:
Many other interest
rates could be found on the light of the fact that any negotiation can
produce a specific rate.
In term of comparison
among their mutual relationships, in some cases it is known which rate
is higher and which is lower but differences (the so-called "spread"
between two rates) can widely vary over time and
Which is the leading
interest rate, in parallel to which all the others move? Does it exist
such an interest rate? Well, in some analysis it may be easier to consider
just one interest rate, but in reality there is no guarantee that all
the others will move exactly in parallel.
1. Different types of interest rate are linked and influence each others, so that the functioning of the financial markets and their international relationships explain a good deal of interest rate fluctuations.
2. Economic performance,
perspective and expectations of potential loan receivers as well as in
the overall economy play an important role.
To keep things easy,
we could say that interest rates are determined in negotiations,
which are more or less public, binding a larger or narrower
number of contrahents, more or less depending on publicly available
In a sentence, interest
rates are set within institutional agreements.
policy is one of the most powerful factor impacting on these agreements,
for example through the instrument of direct determination of official
discount rate or the rate for refinancing operations.
An increase of money
offered in the interbank market by the central bank is conducive to a
fall in the interbank rate, upon which many contracts are based.
To the extent the
Ministry of Treasury influences the interest rates on its own bonds,
it provides an important reference point for the economy.
Since for many banks
the risky commercial loans to firms
are alternative to safe Treasury bonds, there are paradoxically situations
in which the interest rate policy in the hands of the Treasury not less
than of the central bank.
exert an important influence on domestic conditions as well, since financial
markets are now global in scope and there is a growing co-operation among
commercial bank policies say the last words on loan agreements and
general, an increase of interest rates may be provoked by
the following factors alternatively or cumulatively:
contrast, a fall in interest rates may be justified especially by the
The traditional effects
on an increase of interest rates are, among others, the following:
If the rate is kept higher for a longer period of time, also newly agreed fixed rate instruments will adjust up.
Still, the general
environment in which the rise takes place is crucial, since such effects
can be completely absorbed by other (more powerful) forces. A booming
economy might absorbe a small increase in the interest rates possibly
Similarly, a non-linear relationship could be worth considering between the size of rate increase and the differentiated effects on real and financial markets.
fact, a small change in the official discount rate might arguably
have no real effect at all, while triggering substantial
echos on financial markets.
By contrast, a large and abrupt increase in general interest rates can have devasting effects on crucial real variables, exerting a depressing pressure on GDP and the economy at large. In particular, if prices in the real estate (including housing) market and Treasury bonds are falling, their value as collateral for loans would be reduced. The credit crunch would squeeze private investment. If the business environment is such that the State begins to delay due payments to firms and has difficulties in re-finacing its debt (with some risk of default, even if just in long term perspective) banks might be compelled to reduce credit for current business transactions across the supply chain.
A chain of bankruptcies would close down plants, select the surviving firms, and reduce employment. At the local scale, entire neighbourhoods and towns would economically collapse, with empty buildings and dismissed industrial estate, looking for a future urban regeneration.
The effects will be spread unevenly across industries, with some being much more vulnerable. For instance, there is a strong relationship between interest rates and real estate growth or fall, since all sides of the housing and non-residential market usually leverage debt (the purchaser but also the producer of the new real estate). Many sales are inter-linked, with a purchase made by owners that are able to sell their asset and add only the difference (or extract it, depending on the difference in prices between the two sales), which further contributes to the high sensitivity of the sector to interest rates.
rates fluctuate over time with an historical
ceiling, i.e. a maximum level. Even though in high-inflation periods
the nominal interest rate can reach extremely high levels, for long decades
a ceiling of 10% is a rule for many countries.
Nominal interest rates have a minimum floor of zero, with the exception of central bank interest rate for refinancing operations which can be negative as a part of monetary policies aimed to stimulate the economy.
rates primarily depend on policy and expectations, thus
the relationships with the business cycle depend on explicit decisions
and subjective judgements of key players.
the interest rates are mainly used to fine tune the business cycle, then
they will fall in recessions, slightly but steadily rise with
recovery and, finally, will be increased
at the end of the growth period to brake possible inflationary dynamics.
Soft landing will be targeted, even though hard landing with a recession
is an equally likely outcome. In
this case, interest rates are pro-cyclical, with usually short-run
interest rate being more markedly pro-cyclical than long-term rates.
But other policy rules would imply different behaviour. For instance, if the target is mainly inflation, during a stagflation period (a depressed GDP with high inflation) the interest rates may be particularly high, thus a counter-cyclical pattern would emerge.