The Basics of Interest Rates

Understanding the Cost of Money

The cost of money is the opportunity cost of holding money instead of investing it, depending on the interest rate.

The cost of money has its basis, as does the subject of finance, in general, in the time value of money. The time value of money is the value of money, considering the interest earned over time. If offered a choice between $100 today or $100 in a year – and there is a positive real interest rate throughout the year – a rational person will choose $100 today. This is described by economists as time preference.

Time preference can be measured by auctioning off a risk-free security – like a US Treasury bill. If a $100 note, payable in one year, sells for $80 now, then $80 is the present value of the note that will be worth $100 a year from now. This fee paid as compensation for the current use of assets is known as interest. In other words, the concept of interest describes the cost of having funds tied up in investments or savings.

The Cost of Money is the opportunity cost of holding money in hands instead of investing it.

Furthermore, the time value of money is related to the concept of opportunity cost. The cost of any decision includes the cost of the most forgone alternative. The cost of money is the opportunity cost of holding money in hands instead of investing it. The trade-off between money now (holding money) and money later (investing) depends on, among other things, the rate of interest that can be earned by investing.

An investor with money has two options: to spend it right now or to save it. The financial compensation for saving it as opposed to spending it is that the money value will accrue through the compound interest that he will receive from a borrower (the bank account or investment in which he has the money).

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Interest Rate Levels

An interest rate is the rate of interest a borrower pays to use the money they borrow from a lender. Changes in interest rate levels signal the status of the economy. As a vital tool of monetary policy, interest rates are kept at target levels – taking into account variables like investment, inflation, and unemployment – for the purpose of promoting economic growth and stability.

In the United States, the Federal Reserve (often referred to as "The Fed") implements monetary policies largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed.

Federal fund rates The effective federal funds rate in the U.S. charted over more than half a century.

Monetary policies are either expansionary or contractionary. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses to expand. An expansionary policy increases the total supply of money in the economy more rapidly than usual. Contractionary policy is intended to slow inflation to avoid the resulting distortions and deterioration of asset values.

Contractionary policy increases interest rate levels by expanding the money supply more slowly than usual or even shrinking it. Most central banks worldwide assume and expect that lowering interest rates (expansionary monetary policies) will increase investments and consumption. However, lowering interest rates can sometimes lead to the creation of massive economic bubbles when a large amount of investments are poured into the real estate and stock markets.

Crowding Out

Crowding out occurs when expansionary fiscal policy raises interest rates, thereby reducing investment spending. That means an increase in government spending crowds out investment spending. This change in fiscal policy shifts the equilibrium in the goods market. A fiscal expansion increases equilibrium income. If interest rates are unchanged, an increase in the level of aggregate demand will follow. This increase in demand must be met by a rise in output.

With this increase in equilibrium income, the quantity of money demanded is higher. Because there is an excessive demand for real balances, the interest rate rises. Firms' planned spending declines at higher interest rates, and thus, aggregate demand falls. The adjustment of interest rates and their impact on aggregate demand dampens the expansionary effect of increased government spending.

Drivers of Market Interest Rates

The market interest rate is the rate a borrower pays to use the money they borrow from a lender in the market.

Factors Influencing Market Interest Rates

Deferred consumption: When money is loaned, the lender delays spending the money on consumption goods. According to time preference theory, people prefer goods now to goods later. In a free market, there will be a positive interest rate.

Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. If the inflationary expectation goes up, then so does the market interest rate and vice versa.

Worldwide Inflation Rates 2009 World map showing inflation rate by country.

Alternative investments: The lender can invest his money in different ways. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds, boosting the market interest rate.

Risks of investment: There is always a risk that the borrower will file for bankruptcy, abscond, die, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure they are compensated for those that fail across their investments. The greater the risk, the higher the market interest rate will be.

Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged rather than a form that takes time or money to realize. If people are willing to hold more money in their hands for convenience, the money supply will contract, increasing the market interest rate.

Market Impact

There is a market for investments, which ultimately includes the money market, bond market, stock market, and currency market, as well as retail financial institutions like banks. Exactly how these markets function is sometimes complicated.

However, economists generally agree that the interest rates yielded by any investment take into account the risk-free cost of capital, inflationary expectations, the level of risk in the investment, and the transaction costs. This rate incorporates the deferred consumption and alternative investment elements of interest. A basic interest rate pricing model for an asset is presented by the formula: i_n = i_r + p_e + rp + lp.

Assuming perfect information, p_e is the same for all participants in the market, and this is identical to: i_n = i*_n+ rp + lp

where i_n is the nominal interest rate on a given investment, i_r is the risk-free return to capital, p_e = inflationary expectations, i*_n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S. Treasury Bills), rp = a risk premium reflecting the length of the investment and the likelihood the borrower will default, lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).

The Term Structure

Term structure describes how a given quantity or variable changes with time. Regarding bonds, time to maturity, or terms, vary from short-term – usually less than a year – to long-term – 10, 20, 30, 50 years, etc. The term structure of interest rates is often called the yield curve.

In finance, the yield curve shows several yields or interest rates across different contract lengths (2 months, 2 years, 20 years, etc.) for a similar debt contract. The curve shows the relationship between the interest rate (or cost of borrowing) and the time to maturity – known as the "term" – of the debt for a given borrower in a given currency.

The yield curve for USD The U.S. dollar yield curve as of February 9, 2005, has a typical upward-sloping shape.

The curve allows an interest rate pattern to be determined, which can then be used to discount cash flows appropriately. Unfortunately, most bonds carry coupons, so the term structure must be determined using the prices of these securities.

Three main economic theories attempt to explain different term structures of interest rates. Two theories are extreme positions, while the third attempts to find a middle ground between two extremes.

The expectation hypothesis of the term structure of interest rates is that the long-term rate is determined by the market's expectation for the short-term rate plus a constant risk premium. The shortcomings of the expectations theory are that it neglects the risks inherent in investing in bonds, namely interest rate risk and reinvestment rate risk.

The liquidity premium theory asserts that long-term interest rates not only reflect investors' assumptions about future interest rates but also include a premium for holding long-term bonds (investors prefer short-term bonds to long-term bonds). This is called the term premium or the liquidity premium. This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty.

Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward. Long-term yields are higher not just because of the liquidity premium but also because of the risk premium added by the risk of default from holding a security over the long term.

In the segmented market hypothesis, financial instruments of different terms are not substitutable. As a result, the supply and demand in the markets for short-term and long-term instruments is determined largely independently. Prospective investors decide in advance whether they need short-term or long-term instruments. If investors prefer their portfolio to be liquid, they will prefer short-term instruments to long-term instruments. Therefore, the market for short-term instruments will receive a higher demand.

Higher demand for the instrument implies higher prices and lower yields. This explains the stylized fact that short-term yields are usually lower than long-term yields. This theory explains the predominance of the normal yield curve shape. However, because the supply and demand of the two markets are independent, this theory fails to explain the observed fact that yields tend to move together (i.e., upward and downward shifts in the curve).