What is the purpose of interest?

What is the purpose of interest? Why do most economies permit the charging of interest? Could an economy function without interest at all, or is interest necessary for an economy to function?

Interest is a key mechanism to ensure that resources are properly allocated within an economy. There are lots of uses to which money can be put: consuming goods, building highways, constructing a new factory, investing to develop a new drug, etc. Just like goods, the allocation of money is governed by the price system—where the interest rate is the price (because the interest rate is how much you have to pay to get access to money). If the price is too low (i.e. if there is no interest) then few people will be willing to lend money and valuable investments (in, for example, infrastructure or new business ventures) will not take place because the funds aren't available to pay for them. A positive interest rate ensures that people with money they don't need right now have an incentive to lend it to people with valuable projects to fund.

We know that it is possible for economies to function without interest, though, because the charging/payment of interest is prohibited by Sharia law, giving rise to so-called Islamic banking.

• While Islamic banking does not involve the charging of interest, it often does involve transactions structured to compensate the lender for the time value of money, which basically functions as interest from a practical economic perspective, if not a religious law perspective. – Zach Lipton Apr 2 '16 at 22:48

Often, you can hear that "interests" represent the value of money over time. To understand that you could see interest as a form of "reward" for the actor who is lending the money.

For example, I can lend you 100 USD today, however this would prevent me from buying 100 USD today. Because I am willing to consume in, let's say, 1 year, I lend you 100 USD for 1 year. But preventing me from buying today comes to a price, which will be 3 USD (or 3%). Those 3% represent the interest that I am charging over time for my patience, so that you can buy something today !

To get a little bit deeper, one could also say that those 3 USD are split as follow: 2 USD as a reward for me to wait to consume ... And 1 USD of risk (often referred to as the risk premium) that you won't repay me in a year...

Economies have historically permit this because of the logic which is behind: you can buy something today but you have to be aware that this comes to a price and that the bank bears a risk for that.

Having an economy without interests is maybe an interesting theoretical exercise (which you could possibly imagine in taking inflation into account), but would hardly be feasible.

• But, what about Islamic banking and finance? I think it's more than an interesting theoretical exercise and more feasible (or conceivable!) than this answer suggests. – Graeme Walsh Apr 2 '16 at 20:55
• You are making a point. I am not a professional of "Islamic banking" so I prefer to let the stage to more skillful people. My answer was mainly to introduce the concept of interest in a simple way ;-) – Alexis L. Apr 2 '16 at 21:15
• economics.stackexchange.com/a/11060/61 – Alecos Papadopoulos Apr 2 '16 at 23:49
• Exactly. Islamic banking avoids charging interest for the purpose of religious law, but it still, in its different forms, recognizes the time value of money and prices for it accordingly. Transactions are structured differently, but at the end of the day, the bank is still lending with the intent to make a profit on the transaction. – Zach Lipton Apr 3 '16 at 0:15

From a finance perspective, it is possible to break down interest rates as follow:

• Real interest rate, which represents the opportunity cost of lending money (ie. you won't be qble to use that money for other purposes)
• Inflation premium: the purchasing power of a fix amount of money typically decreases over time, which is caused by inflations. Lenders usually want to be protected against this.
• Default risk premium: the borrower might not pay back part or whole of the amount borrowed.
• Liquidity premium: lenders might need urgently to retreive their invested money to face other obligations, or simply they might want to exit the market in a timely manner. This will result in a loss of value of their investment, which might not easily be converted to cash.
• Maturity premium: it is usually considered more risky to lend for 30 years than for 1 month, as the future is blur and hard (if not impossible) to predict. thus all the above risks increase when the maturity is further away.

So overall, the function of interest rates are to reward investors for the risks that they take, being either opportunity costs, or risks of loss on their investment. From that point of vue, interest rates are a necessity because they help allocating the resources in an effective manner throughout the economy. Without interest rates, every projects would be equaly un-attractive, and investors might simply decide to hold their cash in a stash rather than spread it around.

As some already pointed out earlier, some economies claim to refuse interest rates, and seem to still work well. But Shariah-compliant finance seems to be mainly using tricks rather than giving up interests. In particular, some Shariah-compliant funds generate hefty returns investing on fixed income instruments (ie. interest-bearing securities).

Note that negative interest rates exist, but they are mainly caused by regulatory measures which force institutional investor to hold particular assets. It drives up the demand for a limited supply, resulting in negative prices. For example, EU banks must purchase EU A-rated bonds / european government bonds to fill capital / reserve ratio requirements.

I disagree with these answers. Interest must exist in the enconomy as long as there is inflation, because inflation creates a relationship between value and time. For example, assume there is inflation. Joe asks you for $20 to return to you in a year. You can buy a lunch with that or lend him the money. but you'll not be able to buy the same lunch with $20 next year because of inflation so you'd ask him for an interest.

Now why cannot we kill inflation? We can! These crazy economists claim that we need some inflation to allow the economy to be more dynamic to facilitate trades. (canada aims at 2.5% inflation)

I speculate that governments, politicians and millionars put that in as a source of income. How do you think they pay for campaign adds? Now the other answer says that they use it to build highways, drugs...No way! Those come from our taxes.

Some things are best not to know.

• In this case it seems it was best for you not to learn what really causes inflation. (For this comment I got paid \$2 million by the fat cats.) – Giskard Apr 3 '16 at 7:10
• And yet we have interest rates even when inflation is zero. So there's something else going on - a large part of which is the option value of holding money. – EnergyNumbers Apr 3 '16 at 8:26
• In some cases, inflation could be a normal result of an increasing demand for goods in a country (except other reasons like oil prices etc...) don't forget that a deflation is more dangerous (i.e japan in 1990s) – optimal control Apr 7 '16 at 8:49