Intro to Interest Rates
How are interest rates calculated?
To calculate interest rate, multiply the principal amount of money by the time period involved (weeks, months, years, etc.). Then divide the amount of paid interest from that time period by that number.Learn More: How to Calculate Interest on Interest
When will the Federal Reserve raise interest rates?
The Federal Open Market Committee of the U.S. Federal Reserve System meets at least eight times a year. In those meetings, that group directs open market operations, meaning they decide on near-term monetary policy such as tightening or loosening the money supply. That, in turn, raises or lowers interest rates.Learn More: The Federal Funds, Prime, and LIBOR Rates
How do federal interest rates affect the economy?
High interest rates mean there is a high cost to borrow money for companies and households. Higher borrowing costs lower consumer spending and investment spending by companies. That lowers the overall demand for goods and services and lessens inflation.Learn More: Why Interest Rates Affect Everyone
What is a good interest rate on a loan?
The answer to that will vary based on the person or company, and that entity's credit score, the type of loan, and the term of the loan. And it will change over time. For a person with excellent credit, you may find a personal loan with an interest rate as low as 10%.
Interest Rate Parity (IRP)
Interest rate parity is the fundamental equation that governs the relationship between interest rates and currency exchange rates for different countries. It is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
The Fisher Effect is an economy theory that describes the relationship between inflation and real and nominal interest rates. It asserts that the real interest rate equals the nominal interest rate minus the expected inflation rate. So, real interest rates go down as inflation goes up, unless the nominal interest rate goes up at the same rate as inflation.
Nominal Interest Rate
The nominal interest rate is the interest rate before accounting for inflation. The federal funds rate, the interest rate set by the Federal Reserve, is the short-term nominal interest rate. It is the basis for other interest rates charged by banks and financial institutions.
The expectations theory is used to predict future short-term interest rates based on current long-term interest rates. The theory asserts that an investor earns the same amount of interest by investing in two consecutive one-year bond investments as investing in one two-year bond. It also says that long-term rates can be used to indicate the rates of short-term bonds in the future.
The prime rate is the interest rate that commercial banks charge the most creditworthy corporate customers. The federal funds overnight rate is used as the basis for the prime rate, and the prime serves as the starting point for most other interest rates such as mortgages and personal loans.
Overnight rates are the interest rates that financial institutions lend funds to each other at the end of the day in the overnight market. These lending activities help ensure the maintenance of federally-mandated reserve requirements. Overnight rates are predictors of short-term interest rate movement in the economy and can have a domino effect on economic indicators such as employment and inflation.
A dove is an economic policy advisor who promotes monetary policies that involve low-interest rates. These advisors tend to support low-interest rates and an expansionary monetary policy because they value indicators like low unemployment over keeping inflation low.