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When we examine how money affects economic activity, we
will focus on the impact of the interest rate.
Something we've already talked a lot about, but haven't yet really defined.
Technically, the interest rate is the amount of interest paid per
unit of time, expressed as a percentage of the amount borrowed.
Put simply, interest is the payment made for the use of money, and it is often
called the price of money. For example, you may deposit $2,000
in a savings account at your local bank, where the rate of interest is 4% per year.
At the end of the year, the bank will have paid $80 in interest into your account.
Your deposit will be worth $2,080.
Textbooks often speak of the interest rate.
But in today's complex financial system, there
is really a vast array of interest rates.
There are three major reasons why interest rates differ.
First, there is the term or maturity of the loan.
This refers to the length of time until it must be paid off.
This can range from overnight loans to up to 30 years or more for a home mortgage.
In general, longer term loans command
a higher interest rate because lenders are
willing to sacrifice quick access to their funds.
Only if they can increase their return or yield.
Second, there is the degree of risk.
Some loans, such as the securities of the U.S. government, are virtually riskless.
In fact, the interest rate on U.S.
government securities is often called the riskless rate.
In contrast, very risky
investments, which bare a significant chance of default or
non-payment might include the securities of businesses close to bankruptcy.
Cities with shrinking tax bases, or countries
with large overseas debt, and unstable political systems.
These riskier investments might pay 1, 2, or even
5% or more per year above the risk less rate.