Interest Rates: An Introduction by the Federal Reserve Bank of New York

Interest rates receive a lot of attention in the media, but what are they, anyway? How are they determined? What do they do? This introduction provides some basic answers to these questions.

A. Definitions

What is Interest?

Interest is the price that someone pays for the temporary use of someone else’s funds. To repay a loan, a borrower has to pay interest, as well as the principal, the amount originally borrowed.

Interest is the compensation that someone receives for temporarily giving up the ability to spend money. Without interest, lenders wouldn’t be willing to lend, or to temporarily give up the ability to spend, and savers would be less willing to defer spending.

Interest rates are expressed as percents per year. If the interest rate is 10 percent per year, and you borrow $100 for one year, you have to repay the $100 plus $10 in interest.

Because interest rates are expressed simply as percents per year, we can compare interest rates on different kinds of loans, and even interest rates in different countries that use different currencies (yen, dollar, etc.).

What are "APR" and "APY"?

"APR" stands for "Annual Percentage Rate," and "APY" for "Annual Percentage Yield."

The APR includes, as a percent of the principal, not only the interest that has to be paid on a loan, but also some other costs, particularly "points" on a mortgage loan.

Points (a point equals one percent of the mortgage loan amount) are fees that the mortgage lender charges for making the loan. In a sense, points are prepaid interest, or interest that is due when the loan is taken out.

Some lenders charge lower interest rates but more points than other lenders. The APR therefore provides a useful gauge for comparing the total cost of mortgage loans.

For example, a 30-year mortgage with an interest rate of 8.0% and four points would have an APR of 8.44%, while a mortgage with an interest rate of 8.25% and one point would have an APR of 8.36%.

"APY" is the effective interest rate from the standpoint of a person receiving interest. If you have $1,000 in each of two bank accounts, each paying the same interest rate, but the interest is credited more often (let’s say, every month, rather than once a year) on one of the accounts, that account will have a higher APY, because the interest will build up more rapidly than on the other account.

Why Does Interest Exist?

From the lender’s point of view:

• Interest compensates lenders for the effects of inflation, or rising prices. Prices go up every year, so lenders are repaid with dollars that can’t buy as much as the dollars they lent; the lenders must be compensated for that loss of purchasing power
• Interest also compensates lenders for the risks they take. One risk is that nobody knows for certain how much prices will go up during the time that the borrower has the lender’s money. Other risks are that the borrower won’t repay the loan fully, on time, or at all
• For a lender such as a bank, interest covers the costs of staying in business, including the cost of processing loans, and interest also provides the profit that a lender needs to stay in business

From the borrower’s point of view:

• Individuals are willing to pay interest to borrow money in order to be able to spend now, rather than later, on cars and many other items
• Individuals are willing to pay interest in order to be able to afford a large purchase, such as a home, for which they don’t have enough funds of their own
• Individuals are willing to pay interest on loans to pay for education, which can increase their earning ability
• Businesses are willing to pay interest in order to borrow to invest in equipment, buildings, and inventories that will increase their profits
• Some borrowers are willing to pay interest on certain loans because of the associated tax advantages. Mortgage interest, for example, is tax deductible. That means that in calculating how much income tax you have to pay, you can subtract the mortgage interest that you pay from your income
• Banks are willing to pay interest on their customers’ deposits because they can lend the funds at higher interest rates and make a profit

Interest: Cost to Some, Income to Others?

Interest is income to people willing to give up the temporary use of their money. When you put money into a bank account, or when you buy a U.S. Savings Bond, for example, you receive interest income.

Interest is a cost to borrowers. You pay interest, for example, if you don’t pay your entire credit card bill at the end of the month, if you take out a mortgage loan to buy a house, or if you own a business that borrows in order to invest in machinery.

Interest is a signal that directs funds to where they can earn the highest rates, or to where loans can do the most for the economy.

Interest is a measure of the cost of holding money. The rate of interest that you could earn by lending your money is the cost to you of holding your money in a way (such as in cash) that doesn’t earn any interest. Economists use the term "opportunity cost" to refer to what you give up by choosing a certain course of action. By holding money, you give up the interest that you could have earned, so the interest rate measures the opportunity cost of holding money.

Interest is the price of a loan, so it is determined to a large extent by the supply of, and demand for, credit, or loanable funds. Many different parties contribute to the supply and demand for credit.

• When you put money into a bank account, you are allowing the bank to lend the funds to someone else. So, through the bank, you are contributing to the supply of credit in the economy
• When you buy a U.S. Savings Bond, you are lending funds to the U.S. government. Again, you are contributing to the supply of credit
• On the other hand, when you borrow -- to buy a car, for example, or by keeping a balance on a credit card account -- you are contributing to the demand for credit
• Individual savers and borrowers aren’t the only ones contributing to the supply of, and the demand for, credit. Business firms and governments in this country, and foreign organizations, too, affect the demand for, and supply of, credit

Together, the actions of all of these participants in the credit market determine how high or low interest rates will be

How Does Inflation Affect the Level of Interest Rates?

Inflation is one reason interest exists; lenders must be compensated for the decline in the purchasing power of what they lend. So, rates generally are high when inflation is expected to be rapid.

Inflation expectations are based heavily on recent inflation. So, rates generally are high when inflation is rapid.

C. The Fed's Role

What is Monetary Policy?

Monetary policy consists of the efforts of the Federal Reserve ("the Fed," for short), the central bank of the United States, to influence money and credit conditions in the economy in order to achieve the country’s macroeconomic goals.

Those goals include stable prices, high employment, and maximum sustainable growth in the economy. Prices are considered stable when they change slowly enough so that people pay little attention to price changes in making economic decisions.

Growth can be measured by the rate of change of real gross domestic product (GDP) -- that is, the output of the economy adjusted for changes in prices. The level of sustainable growth, the rate at which the economy can grow without causing the inflation rate to accelerate, is determined by how fast the hours worked by the U.S. labor force and output per worker grow.

How Does the Fed Formulate Monetary Policy?

The Fed formulates monetary policy by setting a target for the federal funds rate, the interest rate that banks charge one another for very short-term loans.

Because the fed funds rate is what banks pay when they borrow, it affects the rates they charge when they lend. Those rates, in turn, influence other short-term interest rates in the economy, and, with a lag, economic activity and the rate of inflation.

How Does the Fed Implement Monetary Policy?

The Fed uses open market operations, the sale or purchase of previously issued U.S. government securities, to influence the amounts that banks can lend, thereby raising or lowering the federal funds rate. When the Fed buys securities, it injects funds into the banking system, giving banks more to lend and putting downward pressure on the fed funds rate; when it sells securities, it does the opposite.

The results of the Fed’s monetary policy actions cannot be predicted with precision. The Federal Reserve’s influence over short-term interest rates can create conditions conducive to economic growth, but ever-changing market and political conditions, here and abroad, also heavily influence the millions of economic and financial decisions of households and businesses.

What is the Discount Rate?

The Federal Reserve sets the discount rate, which is the interest rate that banks pay on short-term loans from the Fed. The Fed often makes identical changes in its target for the federal funds rate and in the discount rate. Thus, discount rate cuts typically reflect the Fed’s desire to stimulate the economy, and increases in the discount rate often reflect the Fed’s concern over the threat of inflation.

For monetary policy purposes, the discount rate is not as important as the federal funds rate, because banks don’t borrow very much from the Fed.

The Federal Reserve stresses that it is a "lender of last resort." That means the banks have to try to borrow elsewhere before they come to borrow from the Fed, and it means also that a bank should not ask to borrow from the Fed too often.

D. Interest Rates and The Economy

How Do Interest Rates Affect the Economy?

Lower interest rates make it easier for people to borrow in order to buy cars and homes. Purchases of homes, in turn, increase the demand for other items, such as furniture and appliances, thus providing an additional boost to the economy.

Lower interest rates mean that consumers spend less on interest costs, leaving them with more of their income to spend on goods and services.

Lower interest rates make it easier for farmers, manufacturers, and other businesses to borrow to invest in equipment, inventories, and buildings. Also, the returns that investments will produce in future years are worth more today when rates are low than when rates are high. That gives business more of an incentive to invest when rates are low. Increased business investment, in turn, makes the economy grow faster, as productivity, or output per worker, increases faster.

Interest rates do not seem to affect the amount that people save. That’s because higher interest rates have two conflicting effects on how much people save. First, the higher return that savings can earn gives people an incentive to save more. Second, however, the higher return makes savers feel richer, so they may spend more, rather than save more.

How Do Interest Rates Affect The Value of the U.S. Dollar in the Foreign Exchange Market?

Interest rates can affect the value of the dollar versus that of other countries’ currencies. All other things held constant, when real (inflation-adjusted) interest rates are higher in the United States than in other countries, foreigners want to invest their funds here in order to earn a high return. The resulting increase in the demand for the dollar pushes up the value of the dollar. The opposite can happen when U.S. interest rates are low.

How Does the Health of the Economy Affect Interest Rates?

The health of the economy affects interest rates by influencing the supply of, and the demand for, credit. For example:

People’s incomes fall in a recession, so the amount they save also decreases.

The demand for credit by business generally declines in a recession, as business spends less on new buildings, equipment, and inventories. Also, the Federal Reserve acts to reduce interest rates during recessions, in order to stimulate economic activity.

The federal government’s demand for credit generally rises in a recession, as the reduction in business and consumer incomes reduces tax revenues, and programs such as unemployment insurance require increased spending. The net effect of all of these changes is that interest rates often go down in a recession.

All other things held constant, the rising demand for credit in expansions pushes interest rates up. If the rates that consumers and businesses have to pay to borrow rise too rapidly, however, spending may decline, leading to an economic slowdown.