This paper will take an in-depth look at interest rates. Interest rates remain an integral part of the modern economy. As the global economy continues to develop and integrate, leaders and analysts consistently look to interest rates as both a vital indicator of that system's health and a useful vehicle by which it may be controlled. The paper provides a summary of interest's historical development, its current characteristics, and its impact on economic systems.
Keywords: Compound Interest; Depression; Interest; Principal; Recession; Simple Interest
Lending and borrowing is a formalized, complex, and often daunting process. Still, the practices of lending and credit have been part of human commerce for millennia, although they have evolved considerably during that historical course. In the modern world, lending and borrowing entail such concepts as credit ratings, collateral, assets, and debts.
Two factors to consider when lending and borrowing are time and return. On one hand, the lender seeks to have his or her loan returned as soon as possible (the borrower also hopes to pay off the loan as quickly as he or she can). On the other, the lender's return on that loan must be of value to the lender, reimbursing him or her for the loan as well as the time it took to repay the debt. The primary vehicle used to address these two aspects is interest. The health of an economy's credit and lending systems is vital to short-term and long-term productivity and growth. For this reason, the rate at which interest is applied is integral to both understanding economic trends and, where necessary, correcting negative economic conditions.
This paper will take an in-depth look at interest rates. By providing a summary of interest’s historical development, its current characteristics, and its impact on economic systems, the reader will gain a better understanding of the significance interest rates have as part of the fiscal and economic systems of the twenty-first century.
Lending and borrowing date back as far as prehistoric times, before formalized systems of trade and barter were established. One individual, for example, might lend some seed to his or her neighbor or family member, with the promise that the borrower would return the debt once the fall harvest took place. Of course, a considerable amount of time would transpire between the day the loan was given and the day the loan was repaid, and in light of that fact, some sort of agreement needed to be established whereby the lender was compensated for both the original sum and the time it took for him to receive repayment. This agreement more often than not involved the borrower repaying the debt and adding to that repayment more of his or her harvest than he or she had borrowed (Homer & Sylla, 1964).
Such "contracts" represent the earliest forms of interest payments. Interest is, in essence, the price a person pays for borrowing. Because it entails a repayment that is more than the original sum lent, the money involved is also considered a form of equity for the lender. Typically, the interest rate is determined during the establishment of the loan. Interest rates are expressed as a percentage of the money that is owed over the course of the loan, so that the longer a borrower does not pay his or her debt in full, the more s/he will have to pay over the course of the loan.
Interest is usually divided into two categories: simple and compound. Simple interest adds the interest to the principal (the amount of money originally lent) at the end of the year. For example, a bank that loans $10,000 to a customer might apply a 5 percent simple interest rate. At the end of the year, if the individual has not paid against the principal, he or she would owe $10,000 plus $500 (or 5 percent of the principal), and every year subsequent, $500 would be applied. Compound interest is a more common type of interest, applying the interest to the principal over the course of the loan. For example, the same $10,000 loan would, at the end of the year, have $500 in compounded interest added to it; however, in the subsequent year, the principal would total $10,500 and the interest would be $525, which is 5 percent of $10,500 ("Flexo," 2009).
Central to the calculation of interest is the interest rate, which is normally seen as an annual percentage of the principal involved. Interest rates are determined by dividing the amount of interest by the amount of principal. Of course, there are a number of external elements that can affect the rate at which interest is accrued. Chief among them is the government, which determines the parameters by which interest rates may be applied. The US federal government, for example, assesses the US economy for signs of inflation, deflation, stagnation, recession, and other issues, and raises or lowers interest rates in response to those conditions.
The application of interest rates depends on conditions in the economic system in which the lending occurs. It is therefore important to present a brief history of interest rates and the conditions that can affect such rates over the short and long periods of time.
In the 1920s, the US stock market was skyrocketing. Prices were rapidly increasing as investors took part in the countless opportunities Wall Street had to offer. In 1928 and 1929, however, the federal government became concerned that these astronomical prices were overinflating the market and, as a result, ran the risk of creating a financial bubble. The newly established Federal Reserve's response was to attempt to cool off the market's growth by discouraging stock speculation and lending by making it more expensive to borrow funds through an increase in interest rates.
The theory seemed sound at the time; working to keep legitimate investors involved in the market while discouraging those who did not appreciate the risks of investment. However, in practice, the policy proved overly obstructive, as far more investors stayed out of the market, causing a precipitous drop in prices that began before the chaos that ensued on Black Tuesday, the day in 1929 when the entire market collapsed.
The Federal Reserve again did little to lower interest rates, which further contributed to the ongoing disaster that was the Great Depression. Monetary value decreased significantly and banks became aware that any loan issued would see a high risk of default because of a loss of principal. The Depression lasted even longer than originally anticipated as a recession, due in no small part to the fact that the federal government sought to use it to clear away what it saw as toxic elements of the economy. Even as credit and lending froze, high interest rates were the primary mechanism toward this...
(The entire section is 3034 words.)