- Interest rate(s)
The price(s) of obtaining the temporary use of money that one borrows from someone else who actually owns it, normally expressed as a percentage of the amount borrowed per year. Since loans and loan repayment extend over considerable periods of time and entail more complex security arrangements than a simple cash-on-the-barrelhead exchange, interest rates to be paid are normally spelled out as part of a relatively complex written contract between borrower and lender. Like most other prices in an advanced market economy, the going levels of interest rates are determined in rather well-developed, highly competitive markets (in this case, they are referred to as "credit markets" or "financial markets") by the interaction and mutual adjustment of supply and demand. The demand for loanable funds mainly comes from firms who need them for investment purposes, from households who want them mainly for the purchase of big-ticket consumer durable goods like houses or autos, and from national, state and local governments who want them in order to make up the difference between the amount of money available in the treasury from tax collections and the (larger) amount of money the government has nevertheless decided to spend in financing its various projects and programs. The supply of loanable funds comes mainly from individual household and business firm savings placed with financial intermediary firms such as banks, thrift institutions, and insurance companies or else mobilized directly from individual lenders through the issuance of bonds, notes and other credit instruments tradeable on financial markets. In economies such as our own that allow fractional reserve banking, a considerable portion of the supply of loanable funds comes through credit creation by the central bank and the banking system. It is a serious oversimplification to refer to "the" rate of interest because at any given time there will normally be a whole range of different rates of interest that vary according to (among other things) the particular form of lending (bank savings deposits, personal i.o.u.'s, secured mortgages, collateralized bank loans, corporate bonds, U.S. Treasury notes, etc.), the contractual terms upon which the money is loaned (duration of the loan, repayment schedule, fixed rate or floating rate, national currency in which the loan is to be repaid, etc.), and the perceived degree of risk that the particular category of borrower will default on his repayments. For theoretical or analytical purposes, economists often like to postulate the existence of a "pure" (completely risk free) rate of interest (closely approximated by the rate of return on very short-term U.S. government Treasury bills) and then analyze other real world interest rates in terms of various factors peculiar to particular types of loans that each cause some sort of "premium" to be added on to the pure rate of interest in proportion to the various kinds and degrees of risk entailed (risk of default, risk of inflation or currency devaluation reducing the real value of the repayment over time, risk that the debt would be hard to resell if the lender unexpectedly needs to get his money out before the term of the loan expires, etc.)
The level of interest rates plays an extremely important role on either the supply side or the demand side of very many other important markets in the economy, and for that reason interest rates are often perceived by government policy makers as a potentially powerful tool for manipulating the economy in the interests of promoting growth, controlling inflation, stimulating exports and so on. Large-scale investment projects by business firms such as building new factories (or starting up new businesses) are often financed largely by borrowing, and the level of interest rates plays an important role in determining whether a particular investment project under consideration seems likely to be profitable or not. Thus, a period of very high interest rates (especially very high long-term interest rates) is likely to reduce greatly the amount of new investment undertaken -- with obvious short-term consequences for the level of employment in the construction and machine-tools industries and with longer-term consequences for the country's overall economic growth in the future. Similarly, the level of interest rates plays a large role in the willingness and ability of consumers to purchase new houses, recreational vehicles, automobiles, refrigerators and other big ticket items -- with important implications for the profitability and level of employment in these industries. Interest rates available on savings accounts, bonds, and the like play a role in determining household decisions about how much income to save and how much to spend on immediate consumption. Interest rates (and especially their relationship to the levels of interest rates in other countries) also play a crucial role in affecting the volume of savings entering the country from abroad for local investment or leaving the country for foreign investment purposes -- thus influencing not only investment activity but also the exchange rates of the domestic currency in relation to foreign currencies, and thus the attractiveness of the country's exports to potential purchasers abroad. For all these reasons (and others), governments in the 20th century are nearly always deeply involved in deliberate efforts to influence interest rates by means of monetary policies that encourage the expansion (or, occasionally, contraction) of the money stock through regulatory pressures on the banking system.