Interest in Economics
The sum a lender charges for a loan is called interest. It is sometimes referred to as the interest rate or the discount rate. In other terms, it is the fee the borrower must pay the lender in exchange for the loan.
When people began to charge interest on loans and investments in the 17th century, the word "interest" was first used in the English language. However, this phrase did not become well-known until the 18th century, when economists started utilizing it as a concept in economics to help people understand when to invest money so that there will be enough later on. We shall talk about the interest in economics in this article.
The cost of lending or borrowing money is paid in interest. Investors' rate of return on their investment in a certain asset is referred to as interest in economics. The word "interest" can refer to any asset type where there is a possibility of a return on investment, however, it is most frequently used for financial investments like bonds and loans.
Interest is the cost associated with using capital. Interest is the additional payment the borrower makes to the lender in exchange for capital usage. Interest is not the capital's original purchase price, but rather its current value. The amount of money you received from someone else in exchange for borrowing their money is known as the interest rate. As an illustration, if you borrow $100 from a buddy, he will ask you for $10 in interest so that he can be sure he will receive his money back with extra money.
Types of Interest rate:
Generally speaking, rates of interest fall into three groups, namely:
- Rates of Short-Term Interest Rates of Long-Term Interest
- Gross Interest rate and Net interest Rate
- Nominal Interest rate and Real Interest Rate
Long-term interest rates are those charged for longer periods, whereas short-term interest rates are often charged for shorter durations. Short-term loans have a lower interest rate than long-term loans, but in exchange, they have shorter durations than the latter. This is how these two types of loans differ from one another. While the long-term loan has an adjustable time, the short-term loan has a fixed length.
Gross interest is the term used to describe the entire amount of income that the capital lender receives from the borrower. A small portion of this gross interest is net interest. The following four factors make up the gross interest rate:
Net or pure interest rate: It just covers the cost of the capital loan.
Risk insurance: A portion of the interest that lenders earn is a payment for the risk they took while lending money to borrowers. The interest rate will lower the risk associated with borrowing.
Payment for the inconvenience: Lending money to a party causes the lender a lot of inconveniences.
For instance, if the lender extends a loan for five years, he cannot make repayment demands throughout that time. His funds are temporarily locked away. He finds his investment to be inconvenient. Therefore, by increasing the net interest by one or more percent, he makes up for the difficulty of his investment.
Management compensation: Since every lender must spend money managing a loan, they compensate by increasing the net interest charged on the loan by a little percentage.
The nominal interest rate of interest is tied to monetary terms, but the real interest rate is related to terms of purchasing power. The true return on investment is what holds real interest. Irving Fisher popularized the idea of real interest rates in his studies of stock prices and economic turbulence in the 1920s. He demonstrated that stock prices typically move steadily up or down over extended periods. This consistent trend can be explained by the fact that, depending on whether investors purchase equities at high or low prices, they would receive a bigger or lower expected return as compensation for taking on risk.
The nominal interest rate less inflation equals the real interest rate.
The inflation rate / nominal GDP equals the nominal interest rate.