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In everyday language, interest is the payment, made by the borrower of a sum of money to the lender, that is in addition to the repayment of the amount borrowed. The rate of interest is the price of loans, a critical economic variable. However, its importance extends beyond economics. Payment of interest has been a major issue in ethics, and the Jewish, Christian, and Islamic religions have all had, at least for long periods of their history, outright prohibitions on demanding interest when making loans. The dominant nature of interest varies according to the culture of the society in which it is set. For example, loans made to people who are in need and face severe hardship if they cannot get a loan are an essentially different type of transaction from loans that are made to an entrepreneur to finance business operations that are confidently expected to be profitable. This entry will concentrate on the nature and role of interest in modern market economics.
In technical economic language, interest is a payment for the use of capital, with the rate of interest the price paid for this use. Except in some specialized contexts, interest is a financial variable paid for the use of financial capital or money. Economists often talk of the rate of interest. In practice there is not one rate of interest but many, and the form of the transaction can vary from the usual. For example, one way in which banks borrow is by selling bank bills, or a promise to pay the holder of the bill a stated amount at a stated date in future. The difference between the amount paid for a bank bill and the amount the bank pays back on maturity is the interest on the loan to the bank. Also, of course, interest rates can be on loans of any length of time. Loans from overnight to ten years are common, but some are indefinite, with no commitment ever to repay the money. In addition to the amount paid for the use of capital, interest rates often incorporate a risk premium to compensate the lender for bearing the risk that the capital may not be repaid promptly or at all. The risk of most national governments defaulting is practically zero, so the interest rate they pay can be taken as a measure of the pure interest part of an interest rate.
Interest and Profits
Since the interest rate is a financial variable, one would expect that interest rates are determined by the demand for, and supply of, loans and other financial assets. However, at least since the work of Adam Smith (1723–1790) in the late eighteenth century, the dominant view among economists has been that interest rates will tend toward a figure determined by profits. In equilibrium—that is, in a situation where there is no tendency to change—the rate of interest is equal to the rate of profit on the use of new physical capital goods. Hence, despite disturbances caused by purely financial factors, interest rates are largely determined by nonfinancial or real factors.
The modern form of the theory underlying this process is based on the work of Swedish economist Knut Wicksell (1851–1926). In his pathbreaking book Interest and Prices (1898), Wicksell was concerned with explaining trends in prices. Wicksell calls the interest rate fixed by financial markets the money rate of interest, and the interest rate determined by real factors the natural rate of interest. He starts with a situation in which the money rate is equal to the natural rate. Wicksell then assumes an increase in the natural rate due, say, to a new innovation increasing the productivity of capital goods. The money rate is assumed to remain unchanged. Since the new capital goods are more productive and the interest costs are unchanged, profits will increase, leading to an increased demand for new capital goods in the next period.
Like most other economists of his time, Wicksell thought that the economy was always more or less in a state where there was full employment of both labor and capital. Hence, an increased demand for new capital goods will raise their prices. The incomes of those supplying capital goods will increase, and they will spend more on consumer goods, raising the prices of consumer goods. The money rate of interest has not changed, so it is still profitable to borrow to cover any higher prices of inputs, and the whole process will continue until the banking system raises interest rates to the extent required to make the money rate equal to the natural rate. The reverse process occurs if the money rate is greater than the natural rate and causes falling prices. In both cases, equilibrium is only reached when the money rate of interest changes to be equal to the natural rate, which itself is equal to the profit rate on new capital goods.
This analysis of how a divergence between the natural and money rates of interest causes cumulative movements in prices can be adapted to explain changes in the rate of inflation from some rate widely accepted as normal. It can even include relaxation of the assumption of full employment, as long as any lapses are temporary and are automatically removed by the functioning of the economy. In this analysis, interest is the price that equates the supply of funds from net savings with the demand for funds for investment in new capital goods.
Interest and Money
John Maynard Keynes’s (1883–1946) enormously influential General Theory of Employment, Interest, and Money (1936), among other things, turned the focus of interest rate theory onto financial markets. In contrast to Wicksell’s analysis, Keynes focused attention on why people want to hold money rather than other financial assets such as bonds. The reason for holding money is that it is completely liquid. One can use it immediately. Keynes listed three reasons for desiring liquidity. One is the transaction motive: to make easy both commercial and personal exchanges. Another is the precautionary motive: to have the ability to respond immediately to unforeseen future needs. The last reason is the speculative motive: to try and make a profit by guessing or knowing the future better than the market as a whole. Keynes thought that the major influence on interest rates in the short run was that arising from speculation on the level of future interest rates.
Not surprisingly, given the institutional arrangements of his time, Keynes thought that the volume of money in a country was determined by the central bank. This supply of money, together with the demand for money, especially that resulting from liquidity preference, determined the rate of interest. Today, institutional arrangements are very different. The ability of financial markets to create money is determined by the demand for money, with external constraints much less important. Central banks now rely on more direct ways of influencing interest rates, mainly using changes in the interest rate they charge banks who borrow from them. Nevertheless, Keynes’s emphasis on monetary factors and the allocation of assets remains important.
Fitting together the two theories by using monetary factors to explain interest rates in the short run and real influences to explain interest rates in the longer run does justice to neither theory. In both cases, the determination of the rate of interest is an integral part of the bigger whole. Keynesian economists deny the proposition that the economy trends strongly toward the full-employment position, which is a crucial part of the theory in the Wicksellian tradition. If the Keynesian view is correct and there can be continuing equilibrium at less than full employment, then causation will run more from interest rates determined in financial markets to real variables like output and capital productivity than the reverse. The different theories have very different implications for monetary policy.
Interest Rates as a Link with the Future
Irrespective of how it is determined, the interest rate has a crucial role to play in the allocation of new capital goods. Businesspeople will only buy new capital goods if the expected profit rate on those goods is equal to or greater than the rate of interest. The rate of interest sets the hurdle that determines which of the myriad ways in which new capital can be used are realized. Thus, the interest rate determines now what types of new capital goods there will be in the future, when the output these capital goods help to produce comes on the market.
So far this entry has not discussed the situation where the money borrowed is used to buy consumer goods, rather than capital goods. Here too the interest rate has a role to play in linking the present and the future. A person may borrow to increase current consumption because future income is expected to be greater than present income or future needs to be less than present needs. Alternatively, the borrower may give more weight to consumption in the present than to consumption in the future. The price of consuming more now is given by the interest rate. Generally, the higher the interest rate the less consumption is shifted from the future to the present, though the strength of the relationship may not be strong and for many individuals the desire to consume now may result in future consumption being discounted enough to outweigh any likely rate of interest.
Interest rates can also play a role in decisions about government expenditures and other policies, such as a tariff on imports of a particular commodity or the introduction of restrictions on logging. Cost-benefit analysis can be used to evaluate policy decisions, taking into account wider social criteria and not only narrow economic benefits and costs. There are many technical problems in estimating the various costs and benefits of a particular policy change. The one that is relevant here arises because many costs and benefits will occur in the future. In many cases, more of the costs occur in the near future compared to the benefits, so the choice of the interest rate used to discount future flows of costs and benefits has a major effect on the result. Some argue that the after-tax interest return on risk-free government bonds less the rate of inflation should be used in such analyses. Others argue that, because this is a market rate of interest, it incorporates a higher rate of discounting the future than is appropriate for a social discount rate.
The precise way monetary policy operates depends on the institutional arrangements of financial markets, but there is now widespread agreement that the immediate target of monetary policy is the level of interest rates. The dominant view among economists is that the underlying objective of monetary policy should be to contain inflation, often to keep it in a publicly announced target range. In Wicksellian terms, the objective is to keep the money rate close to the natural rate.
Orthodoxy also allows that, when employment is markedly below full employment, monetary policy can help hasten the return to full employment. Keynesian economists hold that, in the absence of policies to prevent it, a market economy can remain well below the fullemployment level indefinitely. For them, monetary policy has a part to play in restoring full employment.
In countries with floating exchange rates, monetary policy may also be used to support the exchange rate. A freely floating exchange rate, where transactions are not constrained by any controls on capital transactions, is a very flexible price, responding quickly to changes in supply and demand. In the modern global economy, the vast majority of foreign exchange transactions are investments in financial markets where the returns are high. The return to investing foreign funds in a country is the rate of interest obtained in the country plus the expected appreciation of the country’s currency in foreign exchange markets (or less any expected depreciation). Thus, other things being equal, a rise in interest rates will lead to a higher exchange rate or prevent or reduce a fall in exchange rates if depreciation is expected. There have been clear examples of countries raising interest rates to very high levels to prevent a disastrous fall in exchange rates. Behind the scenes, use of monetary policy to support the exchange rate may be more widespread.
In the traditional story, interest rate changes affect inflation and economic activity through their influence on investment in new capital goods. The implication is that this investment is made by businesses. In fact, an interest rate change usually has a stronger direct effect on residential construction by households. It may also affect credit card usage and other forms of household debt.
A second way a change in interest rates can influence the economy is its effect on bank assets. The value of existing financial assets goes down when interest rates rise. When the values of banks’ assets fall, banks are less willing to lend, and a slight or a serious credit squeeze occurs. Many economists think that the availability of credit is more important than the level of the interest rate in transmitting the effects of changes in monetary policy.
The exchange rate also has a part to play in transmitting the effects of changes in the rate of interest. If interest rates rise, the value of a country’s currency will rise on foreign exchange markets. This will make imports cheaper and reduce the return to exports. The low prices for imports will help restrain inflation, and the lower returns in exporting and import-competing industries will discourage investment in these industries.
The exchange rate also has a major influence on the efficacy of monetary policy, especially in the case of small countries with many economic links to the outside world. If the exchange rate is fixed and expected to stay fixed at its current value, monetary policy relies on capital controls to stop people borrowing in foreign countries.
Consequently, monetary policy is usually not effective.
On the other hand, if a country has a freely floating exchange rate, problems arise if a major depreciation of the value of its currency is expected in financial markets. In this situation, monetary policy may have to ignore its usual goals and focus solely on supporting the exchange rate.
More generally, globalization has reduced the efficacy of monetary policy. For example, if rising interest rates reduce the availability of credit from domestic sources, this will be offset to some extent by the willingness of foreigners to lend. The biggest problem is probably the risk that policy aimed at expanding economic activity by reducing interest rates may lead to expectations of a depreciation in the value of a country’s currency. Some depreciation is usually helpful in these circumstances, but a large depreciation can have a serious impact, especially on the distribution of income. The desire to avoid such an impact may hamstring monetary policy in some circumstances. Nevertheless, the general view is that governments still have considerable freedom in domestic macroeconomic management, but since the efficacy of monetary policy has been reduced significantly, more reliance may have to be placed on other policies.
A different aspect of the operation of monetary policy has attracted considerable attention: its effect on the relationship between short-term and long-term interest rates. This relationship is usually called the term structure of interest rates or the yield curve. Central bank operations directly influence short-term interest rates. When the actions of the central bank raise short-term interest rates, longer-term rates may not rise much, since the rises at the short-term end of the market are often considered temporary and liable to be reversed when policy changes. Normally, interest rates rise as the term of the loan lengthens, probably due to increased uncertainty about the level of interest rates in the more distant future. Thus the yield curve slopes upward as the loan lengthens. For the reasons given above, tight monetary policy can flatten, or even invert, the yield curve. Many studies have documented a historical relationship linking a flat or inverted yield curve with a recession somewhat later. Interest has arisen in using the yield curve to predict the level of activity in the genuinely unknown future, but this is a much more difficult exercise.
- Chick, Victoria. 1983. Macroeconomics after Keynes: A Reconsideration of the General Theory (chaps. 9–11). Oxford: Philip Allan.
- Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money (chaps. 13–15). London: Macmillan.
- Kriesler, Peter, and J. W. Nevile. 2003. Macroeconomic Impacts of Globalization. In Growth and Development in the Global Economy, ed. Harry Bloch, 173–189. Cheltenham, U.K.: Elgar.
- Macfarlane, Ian, and Glenn Stevens. 1989. Overview: Monetary Policy and the Economy. In Studies in Money and Credit, eds. Ian Macfarlane and Glenn Stevens. Sydney: Reserve Bank of Australia.
- Solow, Robert M. 1997. Is there a Core of Usable Macroeconomics We Should All Believe In? American Economic Review 87: 230–232.
- Taylor, Lance. 2004. Reconstructing Macroeconomics: Structuralist Proposals and Critiques of the Mainstream (chaps. 3 and 10). Cambridge, MA: Harvard University Press.
- Wicksell, Knut.  1936. Interest and Prices (Geldzins and Güterpreise): A Study of the Causes Regulating the Value of Money. Trans. R. F. Kahn. New York: A. M. Kelly.
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