Savings Interest Rates

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What is Interest Rate?

An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. Interest rates are normally expressed as a percentage over the period of one year.

Causes of interest rates

* Deferred consumption.

When money is loaned the lender delays spending the money on consumption goods. Since 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.

* Alternative investments.

The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.

* Risks of investment.

There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.

* 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 realise.

* Taxes.

Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.

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