What Is Interest Rate?

Macro & Money · Monetary Policy

The intuition

Money today and money next year are different things. Lend out $100 for a year at 5% and you receive $105 back: the $5 compensates you for waiting, for risk, and for the prices that will creep up meanwhile. The interest rate is the price of moving purchasing power across time — the exchange rate between today's money and future money.

Interest rates appear everywhere: savings accounts pay them, mortgages charge them, governments pay them on bonds, and businesses compare them against the returns on new projects. Because every long-lived decision — buying a house, building a factory, studying — trades money now for money later, the interest rate quietly enters almost every economic choice.

Key distinctions: nominal vs real, and policy rate vs market rates. The real rate subtracts inflation: real rate ≈ nominal rate − expected inflation. If your deposit pays 4% while inflation runs 3%, you are earning about 1% in purchasing-power terms.

What sets the level

Central banks set the shortest, most important rate — the policy rate — which anchors the whole structure. Market rates for longer maturities reflect expectations of future policy, plus term premia and credit risk. A 10-year bond yielding more than a 1-year bond often signals expected rising rates or a premium for locking money up; the reverse shape (an inverted curve) has historically preceded recessions.

Underneath sit several forces: how patient savers are, how profitable investment opportunities look, expected inflation (lenders demand compensation for it), and risk — a shaky borrower pays more than a solid one for the same loan.

Why it matters

Interest rates are the main channel through which central banks steer the economy. Raising the policy rate makes borrowing dearer and saving more attractive, cooling spending and investment — the standard response to high inflation. Cutting does the opposite. Every change ripples through mortgages, car loans, corporate finance and exchange rates.

For households and firms the rate is a hurdle. A project is worth doing if its return beats the cost of funds — and that hurdle moves with every policy decision. Rates also encode present value: the higher the rate, the less a future payment is worth today, which is why long-duration assets are the most rate-sensitive.

A worked example

You deposit $1,000 for two years at 5% a year, compounded annually. After year one: $1,050. After year two: $1,102.50 — the second year earned interest on last year's interest.

Now check real vs nominal. If inflation averaged 3% a year, the real rate was about 2%. Your $1,102.50 buys roughly what $1,039 would have bought at today's prices (1,000 × 1.05² ÷ 1.03² ≈ 1,039). The money grew 5% a year nominally, but your purchasing power grew about 2%.

Why the central bank cares: suppose it raises the policy rate from 3% to 6%. Your variable-rate mortgage payment jumps, the car loan costs more, and the savings account finally pays something. Households borrow less and save more; firms postpone expansions. Demand cools — which is precisely the point when inflation is running above target.

Common misconceptions

• ✗ The central bank sets all interest rates.✓ It sets one short-term policy rate. Mortgage, corporate and long-term government rates form around expectations of that rate plus risk and term premia.
• ✗ A high nominal return means you are getting richer.✓ Only the real return matters for purchasing power. An 8% nominal return with 9% inflation is a real loss.
• ✗ Interest is a quirk of modern banking.✓ Charging for the use of money across time appears in virtually every recorded economy; the rate is simply the price of time, risk and inflation compensation.

Frequently asked questions

Related concepts

Sources

• www.econlib.org
• www.federalreserve.gov

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