Interest Rates

Peter Venkman: You won't regret this, Ray.
Ray Stantz: My parents left me that house. I was born there.
Peter Venkman: You won't lose the house. Everybody has three mortgages nowadays.
Ray Stantz: But at 19 percent? You didn't even bargain with the guy.
Egon Spengler: Ray, for your information, the interest alone for the first five years comes to $95,000 dollars.
--Ghostbusters

Last time we discussed the centrality of prices to market functioning. Of the myriad prices powering market behavior, none is more important than those conveyed by interest rates. Interest rates indicate the price of money or, more precisely, the price of borrowed money.

As discussed in a previous post, borrowing requires that you pay back the original amount of a loan (i.e., 'principal') from the creditor along with a charge for borrowing those funds (i.e., 'interest'). The charge, or 'interest rate,' is usually expressed as the percentage of the principal that you pay in interest to the creditor on an annual basis.

For example, if you borrow $10,000 from a bank and you pay $500 annually for use of the money, then the interest rate is $500/$10,000 or 5%.

Previously we observed that prosperity increases when savings are invested in capital improvement projects that improve productivity. Since the cost of productivity improvement projects often exceeds what they can fund out-of-pocket, entrepreneurs commonly tap credit markets for the resources that they need.

Interest rates are vital to markets because they permit calculation of the cost of acquiring capital for investment and productivity improvement. Without the prices conveyed by interest rates, markets could not function.

While interest rates come in many shapes and sizes, there is one interest rate in particular that projects outsized influence on markets. We'll discuss this next time.