What is the Interest Rate

The interest rate can be regarded as the cost of money, expressed as a percentage. If the annual interest rate is 10 percent, an individual borrowing $100 for a year pays $10 interest. Decimalized currency systems substantially facilitated the calculation of interest. This is one reason countries rapidly adopted decimalized currency systems during the nineteenth century.

Theoretically, interest rates adjust to a level at which the interest earned on $100 invested in financial assets (for example, corporate bonds) equals the income earned from the ownership of $100 worth of capital goods (for example, tools, machinery, buildings). During the recovery phase of the business cycle interest rates tend to rise as capital goods become more productive, and in the recession phase interest rates tend to fall as capital goods lose productivity.

During early European history, religious authorities regarded charging interest as a sinful means of earning income. Governments either banned interest, or put a legal ceiling on interest rates. In the United States, state usury laws limiting interest rates were common as late as the 1970s. Most of them have now been repealed.

Historically, the highest peaks in interest rates have occurred during wartime. Interest rates reached historic levels during the Napoleonic Wars and during World War I. Wars are often the occasion for heavy government borrowing and high inflation, both of which are enemies to low interest rates. The legacy of the depression and wage and price controls helped keep a lid on interest rates during World War II, but the era of the cold war, from 1946 to 1983, saw the longest upswing in interest rates occurring since the beginning of the eighteenth century.

Governments may act purposely to reduce interest rates as an antidote to depression. In 1998 the Federal Reserve System in the United States acted to lower interest rates to prevent a global financial crisis from spreading to the United States.