Interest rate

An interest rate is the 'rental' price of money. When a resource is borrowed, the borrower pays the lender for the use of the resource. The interest rate is the price paid for the use of money for a period of time. When money is loaned the lender defers consumption (or use of the money) for a specific period of time. The lender does this in exchange for an increase in consumption. The increase in consumption expected is the real interest rate. The increase in consumption, however, is diluted by the effect of inflation. Thus the actual rate charged (known as the nominal rate) has to take inflation into account. Quite simply the nominal rate is:

rn = rr + i

where:

rn = nominal interest rate
rr = real interest rate
i = projected inflation

Other approximations for the nominal interest rate exist.

rn = rr + i + d + mrp + lp

where

d = default premium (likelihood of default by the borrower)
mrp = maturity risk premium (risk factor for length of borrowing period)
lp = liquidity premium

Fisher Theory of Interest Rates

Irving Fisher proposed a better approximation of the relationship between nominal interest rate, inflation and real interest rate.

(1 + rn) = (1 + i)(1 + rr)

For example: assume the real rate desired is 2% but inflation is running at 5%. Then the lender will charge:

(1 + .05)(1 + .02) = 7.1%

See Also: Term Structure of Interest Rates