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Definitions
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Dictionary > Definitions > Economy > Interest
Interest
Definition
Interest is a fee paid on borrowed capital. By far the most common form in which these assets are lent is money, but other assets may be lent to the borrower, such as shares, consumer goods through hire purchase, major assets such as aircraft, and even en
Description
The charge of interest dates back to 1500 B.C. among the
Sumerian and Egyptian cultures. References to the concept can be found in the
religious text of the Abrahamic religions such as the counsel against excessive
interest.
Interest is the price paid for the use of savings over a given period of time.
In the Middle Ages, time was considered to be property of God. Therefore, to
charge interest was considered to commerce with God's property. Also, St. Thomas
Aquinas, the leading theologian of the Catholic Church, argued that the charging
of interest is wrong because it amounts to "double charging", charging for both
the thing and the use of the thing. The church regarded this as a sin of usury;
nevertheless, this rule was never strictly obeyed and eroded gradually until it
disappeared during the industrial revolution. Some scholars think that banking
started among Jewish families because of the restrictions of the church.
... financial oppression of Jews tended to occur in areas where they were most
disliked, and if Jews reacted by concentrating on moneylending to gentiles, the
unpopularity - and so, of course, the pressure - would increase. This is that
the Jews became an element in a vicious circle. The Christians, on the basis of
the Biblical rulings, condemned interest-taking absolutely, and from 1179 those
who practiced it were excommunicated. But the Christians also imposed the
harshest financial burdens on the Jews. The Jews reacted by engaging in the one
business where Christian laws actually discriminated in their favor, and so
became identified with the hated trade of moneylending.
Usury has always been viewed negatively by the Roman Catholic Church. The Second
Lateran Council condemned any repayment of a debt with more money than was
originally loaned, the Council of Vienna explicitly prohibited usury and
declared any legislation tolerant of usury to be heretical, and the first
scholastics reproved the charging of interest. In the medieval economy, loans
were entirely a consequence of necessity (bad harvests, fire in a workplace)
and, under those conditions, it was considered morally reproachable to charge
interest.
In the Renaissance era, greater mobility of people facilitated an increase in
commerce and the appearance of appropriate conditions for entrepreneurs to start
new, lucrative businesses. Given that borrowed money was no longer strictly for
consumption but for production as well, it could not be viewed in the same
manner. The School of Salamanca elaborated various reasons that justified the
charging of interest. The person who received a loan benefited and one could
consider interest as a premium paid for the risk taken by the loaning party.
There was also the question of opportunity cost, in that the loaning party lost
other possibilities of utilizing the loaned money. Finally and perhaps most
originally was the consideration of money itself as merchandise, and the use of
one's money as something for which one should receive a benefit in the form of
interest.
Martín de Azpilcueta also considered the effect of time. Other things being
equal, one would prefer to receive a given good now rather than in the future.
This preference indicates greater value. Interest, under this theory, is the
payment for the time the loaning individual is deprived of the money.
Economically, the interest rate is the cost of capital and is subject to the
laws of supply and demand of the money supply. The first attempt to control
interest rates through manipulation of the money supply was made by the French
central Bank until 1847.
The first formal studies of interest rates and their impact on society were
conducted by Adam Smith, Jeremy Bentham and Mirabeau during the birth of classic
economic thought. In the early 20th century, Irving Fisher made a major
breakthrough in the economic analysis of interest rates by distinguishing
nominal interest from real interest. Several perspectives on the nature and
impact of interest rates have arisen since then. Among academics, the more
modern views of John Maynard Keynes and Milton Friedman are widely accepted.
Former Central President of the JUP Sahibzada Fazal Karim MNA has stated that
the Council of Islamic ideology feels that Islamic banking ought to be
interest-free by law.
n economics, interest is considered the price of money, therefore, it is also
subject to distortions due to inflation. The nominal interest rate, which refers
to the price before adjustment to inflation, is the one visible to the consumer
(i.e., the interest tagged in a loan contract, credit card statement, etc).
Nominal interest is composed by the real interest rate plus inflation, among
other factors. A simple formula for the nominal interest is:
i = r + π
Where i is the nominal interest, r is the real interest and π is inflation.
This formula attempts to measure the value of the interest in units of stable
purchasing power. However, if this statement was true, it would imply at least
two misconceptions. First, that all interest rates within an area that shares
the same inflation (i.e. the same country) should be the same. Second, that the
lender knows the inflation for the period of time that he/she is going to lend
the money.
One reason behind the difference between the interest that yields a Treasury
bond and the interest that yields a Mortgage loan is the risk that the lender
takes from lending money to an economic agent. In this particular case, the US
government is more likely to pay than a private citizen. Therefore, the interest
rate charged to a private citizen is larger than the rate charged to the US
government.
To take into account the information asymmetry aforementioned, both the value of
inflation and the real price of money is changed to their expected values
resulting in the following equation:
it = rt + 1 + πt + 1 + σ
Where it is the nominal interest at the time of the loan, rt + 1 is the real
interest expected over the period of the loan, πt + 1 is the inflation expected
over the period of the loan and σ is the representative value for the risk
engaged in the operation.
Author
Aziz
Author Email
azizjipsbd@yahoo.com
References
Definitions to be consulted