Interest is the amount of money paid to a lender above and beyond the return of the principal. For example, if someone lends out $1,000 and receives $1,100 back one year later, the principal is $1,000 and the lender earned $100 in interest.
Interest rate is the interest expressed as a percentage of the principal, usually quoted on a yearly basis. In our example, the loan carried a 10% annual interest rate.
It can be quite difficult to explain interest, today we will only go through the basics.
Interest has to do with time. Lenders give up money available to them now, in exchange for a promise to be paid back with money not available until the future. The reason borrowers are willing to pay interest is because they value having money right now, rather than having to put off their purchases until the future.
The interest rate is an exchange rate between currencies, except that the two currencies are current US dollars and future US dollars. (A normal exchange rate would show us how many current US dollars can we trade for one euro or Mexican pesos.)
A business firm needs to use exchange rates if it operates in several countries, in order to keep its accounts in common denominator. If a firm buys Chinese components in yuan, pays workers in Mexico pesos to assemble the parts together and sells the products in the US for dollars, the firm’s accountant(s) will need to translate the three currencies into a common denominator to tell if the business is making a profit.
This same principle can be used on interest rates. If the firm buys raw materials from US suppliers in 2018, then pays American workers to process the materials during 2019, and finally sells the goods in 2020, the firm’s accountant must take into account the time element for the various expenditures and revenues. The dollars paid for materials in 2018, as well as the dollars paid for labor in 2019, have a higher market value than the dollars received from customers in 2020, and so the accountant(s) need to discount the later money. Market interest rates help them determine the appropriate discount to apply, in order to look at the entire three-year operation and decide if they turned a profit.
The higher the interest rate, the more present-oriented business operations will be. If there is a very long operation, requiring inputs of labor and raw materials for many years before the finish product emerges, then the higher the interest rate, the less profitable will the operation be.
On the other hand, a low interest rate gives an opportunity to entrepreneurs to start a longer production process.
Saving & interest
Imagine a scenario where the interest rate is 8%. We will use supply & demand curves to illustrate this initial equilibrium interest rate for the loanable funds market.
The x-axis refers to the total amount of money being borrowed (demanded) and lent (supplied). The y-axis refers to the prices of the loan, which is the same thing as the interest rate. Note that interest isn’t the price of money, it is the price of borrowing money.
In our example, borrowing $100 for a years carries a price of $8; after a person borrows and repays the loan principal, he still has to fork out an additional $8 fee.
The equilibrium interest rate equates the quantity demanded of borrowed money with the quantity supplied of money to be lent. If the interest rate was too high, the lenders would want to lend out more money than borrowers would want to borrow. If the interest rate was below 8%, there would be a shortage of loanable funds, as borrowers would seek to borrow more than lenders would be willing to supply. In our example, only at an interest rate of 8% we have an equilibrium.
Now what happens if most people in the community decide to save more?
Supposing the suppliers (people who started saving their money) would be willing to bring more of their saved funds to the market to lend out to borrowers, we would experience a rightward shift in the lend (supply) curve, making the rate of interest fall down to 6% and thus increasing the total amount of dollars lent and borrowed.