How does inflation and interest work?

Question

I’ve heard that interest is when someone borrows your money they pay back extra for borrowing it. is this true?

In: Economics

Answer 1

True. If you lend me $1000 for a year at a rate of 5% interest per year (for the sake of simplicity, we’ll ignore the issue of compounding), then that means that after one year, I have to pay you back the original $1000 plus 5% – that is, I have to pay you back $1050.

Interest is mainly compensation for risk. There’s a risk that I might not be able to pay you back all – or even any! – of the $1000 when the year is up. If you lent me the money at zero interest, there would be a significant potential downside for you, and no upside. In other words, you would have no reason to lend me the money, unless I were a close relative, or your best friend, or had dirt on you, or something. But if you charge interest, now there’s a potential upside for you that compensates for the potential downside of me not repaying the money.

This is why, as a rule, the riskier the loan, the higher the rate of interest.

Interest is also compensation for the fact that you won’t have easy access to the money for the year that you lend it to me. (This is called the “time value of money”.)

Finally, interest is also compensation for the other thing you asked about – inflation.

Inflation is a rise in the general price level. 5% annual inflation means that prices of goods and services have, on the whole, risen by 5% in a year. If you lend me the $1000 at 5% interest, and I pay you back the full $1050, but there was also 5% inflation that year, then you’ve really gotten screwed, since now you need $1050 just to buy the same stuff that would have cost you $1000 last year. In practical terms, you’ve gained nothing – the effect is the same as if you’d lent the money at zero interest.

This is why the expected rate of inflation generally gets incorporated into the interest rate. If you’d had a crystal ball and could see that there was going to be 5% inflation in the coming year, it would have been rational for you to charge me 10% interest instead of 5%, in order to cancel out the effect of the inflation.