Interest is the price a person pays for using money that comes from another source. In other words, it is the return that a lender receives for deferring his consumption by lending funds to a borrower. Interest rates are the rates at which interest is payable for loaned amounts and are usually calculated over the time period of a year. Interest rates are used by the Federal Reserve as tools of monetary policy to control variables like unemployment and investments.

There are several reasons for the presence of interest rates in our economic system. Deferred consumption is one of the reasons. When money is loaned the lender delays spending the money and hence saves as well as earns through the interest rate. A second reason is inflationary expectations. Most economies generally exhibit inflation, which means a given amount of money buys fewer goods in the future than it would now. The borrower needs to compensate the lender for this, hence the need for interest rates.

A third reason is the risk associated with investments. There is always a risk that the borrower might go bankrupt, abscond, or otherwise default on the loan. To play it safe, a lender generally charges a risk premium to ensure that across his investments, he is compensated if somebody fails to pay him back. A fourth reason is liquidity preference. This means that people prefer to have their resources available in a form that can immediately be exchanged, or in other words, a form that does not take time or money to get the value of the resources realized.

A large part of the economic system comprises of the investments market. This includes the bond market, stock market, money market, currency market and retail financial institutions like banks. In such a market, it has been generally agreed by economists that the interest rates result in balancing the system as a whole.

Interest rates are usually linked to the inflation rate and vary depending on the nature of the loan or investment. The greater the risk associated with a loan or investment, the greater is the interest rate charged. Secured loans such as mortgages are usually available at lower interest rates compared to unsecured loans such as credit card loans.

Most financial institutions decide their interest rates using the discount rate decided by the Federal Reserve as a benchmark. When the Federal Reserve raises or lowers this rate, the financial institutions generally follow suit.