Your deposits in a bank account may draw interest. Why does your bank pay interest? The answer seems obvious: Banks make loans at higher interest rates than they pay depositors. Most loans, however, are made to business investors who buy capital—machines or buildings. Thus, interest is ultimately a payment to providers of economic capital. Interest payments are somewhat roundabout in advanced economies, being spread among those who own capital directly and others whose saving and financial investment make it possible for society to accumulate economic capital.
We will focus on interest payments to holders of financial capital to simplify our analysis. Similar reasoning applies to direct owners of economic capital.
Nominal interest rates are the percentage monetary premiums paid per time period for the use of money.
The ultimate lenders are those who save by spending less than their income. If you pay a dime annually for each dollar you owe on a car loan, the annual interest rate is 10 percent. (The people you truly owe are depositors in the lending institution.) Because of differences in borrowers and debt instruments---car loans, mortgages, government or corporate bonds, and so on---there are many nominal interest rates at any given time. These "IOUs" are a large component of our financial capital. Interest rates vary among these financial instruments because of:
1. Risk. Different borrowers have different probabilities of defaulting on their loans. Naturally, higher "risk premiums" in the interest rate are charged the greater the risk of default.
2. Maturity. Interest rates are generally higher the longer it will take to retire a loan, in part because lenders have sets of expectations that become increasingly uncertain as the time period considered becomes longer.
3. Liquidity. Better developed markets for specific debt instruments drive interest rates down, because the transaction costs incurred in buying or selling such IOUs will be lower. Competition among lenders to grant certain types of loans facilitates liquidity.
Interest rates commonly range from a government-subsidized 5 percent annually to a loan shark's 5 percent weekly. References to "the rate of interest" usually mean the nominal interest rate charged annually on long-term (20- to 30-year) riskless loans. Interest rates on negotiable long-term government bonds or those charged to "prime" borrowers are reasonable approximations.
Changes in the price level drive wedges between nominal and real interest rates.
The real interest rate is the percentage purchasing power annually paid by borrowers to lenders.
Real interest rates can be roughly computed by subtracting the percentage annual rate of inflation from nominal interest rates. For example, 8 percent nominal interest yields only about 5 percent real interest if annual inflation is 3 percent.
Equilibrium Interest Rates
Equilibrium in the financial capital market is shown in Figure 6. The initial demand for funds D0 reflects the rates of return expected by business (plus consumer or government borrowing). It is negatively sloped, because investments become less profitable as interest rates rise. The initial supply curve S0 is positively sloped because household saving grows as interest rates paid savers rise (the opportunity costs of current consumption rise).
The rate of return on new investment equals the interest rate in equilibrium, which occurs at the intersection of the demand (D0) and supply (S0) curves in Figure 6 (point e). The initial equilibrium rate of return and interest rate will be 10 percent, and the quantity of investment loans will equal Q0. Suppose that expected returns on new capital investments rise so that the demand for loanable funds increases to D1. Equilibrium interest and investment loans would rise to 12 percent and Q1, respectively (point a). When investors grow more optimistic, expected rates of return, interest rates, and financial investments all rise.
Similarly, suppose households decide to delay consumption and save more. When families increase the rate at which they postpone consumption, the loanable funds available for investment rise, supply shifts from S0 to S1, and interest rates fall (point b).
FIGURE 6 The Market for Loanable Funds
In summary, interest rewards households who save for deferring their consumption and for sacrificing liquidity. Interest is also a return to capital that depends on capital's marginal productivity. The interest rate charged on a particular financial instrument depends on its liquidity and length of time to maturity, and on lenders' perceptions of the probability of default.