In modern economies, some individuals earn more money than they need to spend on present goods. There are other individuals who have a desire for more money than they can presently access. A natural market arises between those who have a surplus of present funds (savers) and those who have a deficit of present funds (borrowers). Savers, investors and lenders are only willing to part with money today because they are promised more money in the future; it's the interest rate that determines how much more.
Supply and Demand for Loanable Funds
The interest rate describes how much borrowers need to pay for loans and the reward that lenders receive on their savings. Like any other market, the market for money is coordinated though supply and demand. When the relative demand for loanable funds increases, the interest rate goes up. When the relative supply of loanable funds increases, the interest rate declines.
The demand for loanable funds is downward-sloping and its supply is upward-sloping. The natural rate of interest in an economy balances out this supply and demand. This mechanism sends a signal to savers about how valuable their money could be. Similarly, it informs possible borrowers about how valuable their present use of the borrowed money needs to be to justify the expense.
The natural rate of interest is mostly a theoretical construct in contemporary economies. Central banks, such as the Federal Reserve, manipulate interest rates to influence monetary policy. For example, a central bank can make it cheaper to borrow and less valuable to save by lowering interest rates in the economy. These actions change the intertemporal incentives faced by economic actors.
Interest Rates, Capital Structure and the Economy
Suppose an entrepreneur wants to start a new manufacturing company. The entrepreneur cannot start earning sales income until the factors of production, such as factories and machines, are in place and operational. This production framework is sometimes referred to as the business capital structure.
Most entrepreneurs don't have enough money saved up to purchase or build factories and machines. They usually have to borrow the startup money. It is much easier to borrow if the rate of interest on the loan is low, because it will cost less to pay it back. If the interest rate is so high that the entrepreneur isn't convinced that he or she can earn enough to pay it back, the business may never get off of the ground.
This is how the interest rate helps determine the overall capital structure of the economy. There has to be enough savings for all of the houses, factories, machines and other capital equipment. Additionally, the subsequent capital structure has to be profitable enough to pay back the lenders. When this coordinating process malfunctions, asset bubbles can form and whole sectors can be compromised.
Liquidity Preference Vs. Time Preference
Economists disagree about the exact nature of interest rates. Interest rates have to coordinate past and future consumption, and they place a premium on risk and the safety of liquidity. This is essentially the difference between liquidity preference and time preference.