Question

Interest rates can be thought of in three ways. List them and explain each.

Answer 1

Interest rates can be thought of in three ways: compensation for delaying consumption, adjustment for inflation, and a risk premium.

Step-by-step explanation:

Interest rates can be thought of in three ways:

1. Compensation for delaying consumption: When individuals invest or save their money, they forgo immediate consumption. In return for this delay, they receive interest on their investments or savings.
2. Adjustment for inflation: Interest rates also account for the increase in the overall level of prices over time. This adjustment ensures that the purchasing power of the money invested or loaned remains relatively stable.
3. Risk premium: The riskiness of the borrower affects the interest rate. Lenders demand a higher interest rate when lending to borrowers with a higher risk of default.

For example, if you deposit money in a savings account, the interest you receive compensates you for not spending the money immediately. The interest rate also takes into account any inflationary rise in prices and may vary depending on the riskiness of the bank.