You are here

Causes of interest rates

29 April, 2015 - 15:03
  • Deferred consumption. When money is loaned the lender delays spending the money on Consumption (economics)|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.