Interest Rates

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

Overview

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 twenty-first century, 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 & Interest: An Introduction

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 their harvest than they 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 their debt in full, the more they will have to pay over the course of the loan.

Simple & Compound Interest

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, they 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).

Interest Rate

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 short and long periods of time.

Further Insights

Interest Rates & the Great Depression

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 end (DeLong, 1997).

When Franklin D. Roosevelt assumed the presidency in 1933, interest rates had come down to nearly zero, as the value of the dollar was at negligible levels, and lending was at a virtual standstill. The low interest rates caused an increase in interest-sensitive spending on durable goods, such as car sales, while consumer spending on services remained stagnant (Romer, 2009), a rare bright spot in an otherwise bleak economic environment.

The example of the Great Depression points to two interesting points pertaining to interest rates. First, they may be set (or reset) by the government in order to offset negative fiscal conditions. The failure of President Herbert Hoover’s administration to do so was seen by many as part of the myriad of influences that perpetuated and exacerbated the Great Depression. Second, interest rates may adjust themselves naturally in parallel to economic conditions—the crash of prices during that period sent interest rates downward as well.

The Great Depression is considered an extreme case of economic collapse in the international economy, and it is still viewed as one of the most significant economic periods in modern world history. Throughout the twentieth century and in the early twenty-first century, there have been smaller (though not insignificant) contractions in the economy. Interest rates once again played a role in the causes of and solutions to these periods.

Recessions

As suggested earlier, the Great Depression has long stood as the standard example of the most feared economic condition into which a system might fall. However, the wounds of the Depression were so deep that, in the years that followed, affixing the term "depression" to an economic downturn (prior to the 1930s, the term was used commonly in this context) amounted to rekindling fears of a return to that dark period. The alternative term for such economic downturns, recession, has helped foster an image of a condition whose duration and scope can be quantified, as opposed to the near fiscal chaos of the 1930s. The difference between a depression and a recession, many argue, is a matter of perception. In the late 1970s, for example, when President Jimmy Carter’s economic adviser Alfred Kahn spoke of a fear of an impending "depression," he was immediately rebuked by the president, who did not want to scare the public by warning of an impending depression. During Kahn’s next speech, he cautioned instead, "We're in danger of having the worst banana in forty-five years" ("Diagnosing depression," 2008).

Since the Great Depression, the United States has experienced a number of economic recessions. In the twentieth century, long recessions occurred from 1973 to 1975 and from 1981 until 1982 (both lasted sixteen months each). The recession that began in December 2007 lasted eighteen months until June 2009 and is often referred to as the Great Recession due to its length and scope (Weinberg, n.d.). During that time, 86 percent of industries in the United States reduced their production, every state reported an increase in unemployment rates, and the average household wealth dropped considerably. The gross domestic product, the most extensive measuring tool for economic performance, slipped approximately 3.4 percent, its worst fall since World War II, but this decline nevertheless pales in comparison to the 26.5 percent drop in GDP that occurred between 1929 and 1933 during the Great Depression (Isidore, 2009).

The 2007 recession paints an important illustration of the impact of interest rates on the economy. One of the bright spots of the recession in 2009 was the fact that gasoline prices declined after a year in which gas prices topped out at a national average of $4.11 per gallon. High interest rates coincided with that rise in oil prices—when the price of fuel fell, so too did interest rates, helping to breathe new life into the housing market and other lending areas. Ironically, the coinciding drops in gasoline prices and interest rates in late 2008 and early 2009 led many consumers to believe that the recession was coming to an end. The result was increased consumer confidence and, due to the resulting increase in consumer demand, a return to higher gas prices and interest rates.

One of the largest contributors to the ongoing recession was the inability of consumers to pay back credit card and mortgage debt. This issue sent shockwaves through the financial sector, causing many banks to fold and others to look to the government in 2009 for assistance. In response, the Bush and Obama administrations and the US Congress implemented two major recovery spending packages, adding nearly $1.5 trillion to the federal deficit. In fact, the administration's ambitious spending requests, coupled with long-standing costs of military operations in Iraq and Afghanistan, caused the deficit (spending versus tax collections) to bloat well beyond historical levels (Montgomery, 2009). As the deficit soared to record levels, the Federal Reserve lowered the short-term interest to 0 percent in December 2008 for the first time in history.

The Great Recession and similar recessions throughout the twentieth and twenty-first centuries provide examples of how economic conditions can drive interest rates up and down based on consumer confidence, federal deficits, and other factors. They also provide examples of how leaders may use interest rates to address key issues that may create or continue recessions.

As the US economy slowly recovered from the recession, unemployment and stagnant production kept wages low. Meanwhile, fears of inflation caused by the monumental influx of money into the economy by the government were downplayed. In order to facilitate economic recovery, the US Federal Reserve argued against increasing interest rates (Cooper, 2009), citing the Great Depression and the 1990s Japanese recession as examples. In those cases, increasing interest rates and tightening fiscal policies before recovery was established helped to maintain economic stagnation. By reducing the short-term interest rates to historically low levels, the Federal Reserve eased the cost of borrowing to encourage easy access to credit in order to increase consumption.

In the years following the COVID-19 pandemic, the US economy struggled to rebound, and inflation once again became an issue. In 2023, the failures of Silicon Valley Bank and Signature Bank were indicative of economic turmoil. Though the Federal Reserve stated the banks’ failures were due to mismanagement, the incident still played out ominously in American media (Rugaber & Sweet, 2023). In 2022, inflation rates in the US reached an all-time high of 9.1 percent. To address rising prices, the Federal Reserve raised interest rates throughout the early 2020s. In 2022, the Federal Reserve raised interest rates a record seven times to counteract economic trends (Pino, 2023).

Conclusions

The rate at which interest is applied is a critical factor in a given economic system. As this paper has demonstrated, interest rates play a central role in the short and long-term health (or lack thereof) of an economy. The significance of interest rates is twofold. First, they are effective tools of economic policy. As seen in the examples of the Great Depression, government-sanctioned higher interest rates contributed to the reluctance of consumers to invest both before and at the tail end of that period. The failure of the Hoover administration to lower those rates is widely considered to have heightened the Depression's longevity and severity. At the outset of the recession that began in December 2007, the Bush and Obama administrations calculated the government’s response to one of the worst recessions since the Depression; it took into consideration the mistakes of the Hoover administration and deliberately kept interest rates low in order to help foster investment and debt repayment.

Second, while the government may intervene to raise or lower interest rates, this economic component has natural forces behind it. The rate of inflation, consumer confidence levels, the rate of production, and other macroeconomic factors may affect a change in interest rates, driving them upward or downward. This effect may, in turn, exacerbate or benefit an economy.

Interest rates remain an integral part of the modern economic system. 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 remain healthy.

Terms & Concepts

Compound Interest: Interest that is applied based on the principal per annum plus accrued interest from previous years.

Depression: Widespread economic decline that persists over a long period of time.

Interest: The price a consumer pays for borrowing money or goods.

Principal: In lending relationships, the amount of money originally lent to the consumer.

Recession: A short-term period of widespread economic decline.

Simple Interest: Flat rate of interest applied to the principal at the end of a year.

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Suggested Reading

Barro, R. (2006). Rare disasters and asset markets in the twentieth century. Quarterly Journal of Economics, 121, 823-866. Retrieved June 24, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21722271&site=ehost-live

Landon-Lane, J. & Rockoff, H. (2007). The origin and diffusion of shocks to regional interest rates in the United States, 1880-2002. Explorations in Economic History, 44, 487-500. Retrieved June 24, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25746000&site=ehost-live.

Laubach, T. (2009). New evidence on the interest rate effects of budget deficits and debt. Journal of the European Economic Association, 7, 858-885.

Little, S. & Mirfin, D. (2005, September 19). Are there any benefits to interest rates being compounded monthly for lifetime mortgages? Mortgage Strategy, 26. Retrieved June 24, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18397407&site=ehost-live

McNulty, L. (2013). Bank of England: the risk of zero interest rates. International Financial Law Review, 32, 42. Retrieved November 21, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=89074228

Samuelson, R. (2003, December 15). Greenspan's finest hour? Newsweek, 142, 39. Retrieved June 24, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=11614078&site=ehost-live