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- Interest – the return a saver receives in addition to the original amount deposited, as well as the amount a borrower must pay in addition to the original amount borrowed. (from Joseph Stiglitz and Carl Walsh Economics 4th Edition p. A-5)
- Interest rate – the rate at which a loan will be repaid or a saver will receive for making funds available.
- If you were to deposit $100 into a savings account with an interest rate of 3 percent for a year, when you asked for your money back the next year, you would receive your $100 + ($100*.03) = $103.
- The bank is able to give you more than your $100 because they took your money and loaned it to, let’s say someone looking to buy a house. That person gets your $100 now but promises to pay the bank the $100 later plus interest. If the interest rate is 4 percent then one year later they will pay the bank $100 + ($100*.04) = $104.
- How is the interest rate determined?
- In the long run the interest rate is determined in a market with supply and demand – much like the market for apples. In this case, however, loanable funds are being sold. The supply is savings (you supply money to the bank to be loaned out) and the demand is investment (business looking for loans come to the bank and ask for money). The price that clears the market is the interest rate. The interest rate in the long run insures that savings (supply) equals investment (demand).
Because the long-term interest rate reflects on the structure of the economy, aligning these rates became a part of the Maastricht treaty.
- In the short run the interest rate is determined by the supply and demand of money.
- The difference in the short and long run has to do with the theory of aggregate supply, and how prices are sticky in the short run. Sticky prices prevent markets from clearing right away. Because markets do not clear right away, there is a role for money. (See an introductory textbook for a more detailed explanation such as N. Gregory Mankiw’s Principles of Economics 4th Edition p. 782.)
- The supply of money is controlled by the monetary authority and does not respond to the interest rate (i.e. the Fed does not look at the interest rate a decide what to do; it looks at other variables such as inflation and unemployment). The demand for money does respond to the interest rate. If the interest rate is high, you would rather have your money in the bank earning interest. As a result, you demand less money in your pocket. The interest rate clears the market for money and insures that money demanded equals money supplied.
- Monetary policy is conducted by changing the money supply and thus the short-run interest rate. The short-run interest rate, in turn, changes investment and thus aggregate demand. In this way the monetary authority can control economic fluctuations.