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interest, charge for the use of credit or money, usually figured as a percentage of the principal and computed annually. Simple interest is computed annually on the principal. Compound interest, paid by some savings banks, computes the interest on the principal as well as on any previous interest that has been added to the principal.

Such charges have been made since ancient times, and they early fell into disrepute. In Greece, Solon forbade selling men into slavery for unpaid interest. The Jews, the Christian Church, and Islam forbade interest charges, or usury, as it was called, among their own groups. The merchant princes of Italy and elsewhere evaded such restrictions, even though the medieval churchmen considered money barren, or unable to produce wealth. Gradually the distinction was made between low interest rates and high ones, which came to be known, and condemned, as usury. England in 1545 removed the prohibition on interest charges and fixed a legal maximum interest; other countries followed.

In modern economics, a number of different theories regarding interest have been influential. The classical theory of interest, developed by Adam Smith and David Ricardo and expanded by others in later years, posited the interest rate as the force which balanced savings with investment. Marxist economic theory argued against the classical view that saw interest rates as a function of natural market forces, contending instead that interest was purely exploitative, because no service was rendered and it benefited only the capitalist class.

Abstinence theory, developed by Nassau Senior and later expanded upon by Eugen Böhm-Bawerk's productivity theory, argued that interest was a reward for saving money (in an interest-earning bank account) rather than spending it on commodities. Greater returns were available to those who saved, and interest rates were the deciding force in saving or spending. Irving Fisher advanced productivity theory by adding human capital to the understanding of interest rates. He explored the willingness (or lack thereof) of individuals to give up their present income for a future income, which may be significantly greater, as an important factor in the decision to invest. John Maynard Keynes took a much different approach, arguing that interest rates were a sort of reward for giving up liquidity, and varying interest rates were the significant force in a decision to invest. This new model was fundamental to the understanding of fluctuating interest rates, stepping beyond the focus of classical economics on equilibrium rates.

In recent years, the problem of inflation has been the paramount issue for interest theory. In the United States, the individual states are responsible for setting a legal rate at which debts may be assessed if they have come due and remain unpaid, and for setting the maximum rate allowed in a contract. In 1981, when rates soared to record highs, many legislatures increased or abolished such maximum rates in order to attract businesses involved in lending. In Great Britain legal interest rates are not fixed by the government, but courts can determine whether a given rate is injurious.

High interest rates can dampen the economy by making it more difficult for consumers, businesses, and home buyers to secure loans, as happened in 1981 when the prime rate—the rate that banks charge their best customers—climbed past 20%. Economists differed over the causes of such extraordinary rates, but inflationary expectations, federal budget deficits, and the restrictive monetary policies of the Federal Reserve System were important factors. Interest rates fell in the latter half of the 1980s and stayed low into the 2000s. In 2001–3, during recession and subsequent slow growth, the Federal Reserve lowered its short-term rates to levels not seen since the 1960s and late 1950s, but the low rates produced the desired economic growth only gradually. In mid-2004 the Federal Reserve began gradually but steadily raising rates until mid-2006, when the short-term rate reached 5.25%.

Bibliography

See D. Dewey, Modern Capital Theory (1965); D. Patinkin, Money, Interest, and Prices (1989); C. Rogers, Money, Interest and Capital (1989).

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interest

Price paid for the use of credit or money. It is usually figured as a percentage of the money borrowed and is computed annually. Interest is charged by the lender as payment for the loss of his or her money for a period of time. The interest rate reflects the risk of lending and is higher for loans that are considered higher-risk, a relationship known as the risk/return tradeoff. Like the prices of goods and services, interest rates are responsive to supply and demand. Theories explaining the need for interest include the time-preference theory, according to which interest is the inducement to engage in time-consuming but more productive activities, and the liquidity-preference theory of John Maynard Keynes, according to which interest is the inducement to sacrifice a desired degree of liquidity for a nonliquid contractual obligation. Interest rates may also be used as a tool for implementing monetary policy (see discount rate). High interest rates may dampen the economy by making it difficult for consumers, businesses, and home buyers to secure loans, while lower rates tend to stimulate the economy and encourage both investment and consumption.