Money, credit and interest · RiskAtoms Academy

By the end you will be able to

1Explain what money is, and why interest is the price of credit.
2Calculate one year's interest on a loan, and the rate implied by a repayment.
3Name the building blocks of an interest rate: waiting, expected inflation, credit risk and costs.
4Describe how a bank creates money when it makes a loan.

Why it matters

In early 2021, a typical 30-year fixed mortgage in the United States cost under 3% a year. By October 2023 it cost more than 7%. Same kind of house, same kind of borrower. What changed was the price of credit, and with it the risk carried by every bank, borrower and bondholder.

Core explanation

Money, credit and the price of time

What money is. Before money, people bartered: a farmer with wheat who wanted shoes had to find a shoemaker who wanted wheat. Money removes that problem. Economists define it by the three jobs it does:

Medium of exchange

Everyone accepts it in payment, so you can sell wheat to one person and buy shoes from another.

Unit of account

Prices are written in it, so a coffee and a car can be compared on one scale.

Store of value

You can keep it and spend it later, though inflation slowly eats into it.

Sort itWhich job is money doing?

0 of 5 right

You tap your card to pay for groceries.
A company reports its profit as ¥3 billion.
You keep $500 in your current account for next summer's holiday.
A shop labels a jacket at £80 and a shirt at £30.
An employer pays wages into staff bank accounts.

Most money today is not notes and coins. It is bank deposits: numbers in accounts that banks promise to pay on demand. That matters, because it means banks are not only stores of money. They also make it.

Credit: money now, repaid later

Credit is any arrangement where you get money now and promise to repay it later: a mortgage, a credit card, a company bond, a government bill. The amount borrowed is the principal. The borrower pays the lender interest on top.

When a bank makes a loan, it does not hand over coins from a vault. It types a new deposit into the borrower's account. Step through what happens.

Step throughHow a bank loan creates money

1 / 5

1

Tom asks for a loan

Tom's bakery asks its bank for €10,000 to buy an oven. The bank checks his accounts and agrees.

Banks cannot create money without limit. They must lend at a profit, keep enough capital and cash to stay safe, and the central bank's interest rate sets the cost of the money they need to settle payments with each other (L1.2.08).

Interest is the price of credit

Every price balances what buyers want against what sellers will supply. Credit is no different: the buyer is the borrower, the seller is the lender, and the price is the interest rate. When many people want to borrow and few want to lend, rates rise. When savings are plentiful, they fall.

A lender asks to be paid for four things:

Waiting. Money lent today cannot be spent today.
Expected inflation. If prices rise 3% a year, money repaid in a year buys 3% less. The lender wants the rate to cover that loss of buying power.
Credit risk. Some borrowers will not repay. The lender adds a premium for that chance.
Costs and other premiums. Checking, servicing and collecting loans costs money, and a loan that is hard to sell before it ends is worth a little extra too.

Build some rates yourself. Pick a borrower and push expected inflation up and down. Notice that inflation moves every rate, while credit risk separates them.

ExploreBuild an interest rate

Illustrative annual rates, chosen to show the shape, not market quotes.

Expected inflation2.0%

Bond of a large, strong company

Reward for waiting1.0%
Expected inflation2.0%
Credit risk1.0%
Costs and other premiums0.5%

Interest rate4.5%

Interest on 1,000 for one year: 45.00

The formal version

For a loan over one year, the interest is the principal times the annual rate. Write $P$ for the principal, $r$ for the annual rate as a decimal and $I$ for the interest:

I = P \times r \qquad \text{and so} \qquad r = \frac{I}{P}

The amount repaid at the end of the year is $P + I = P(1 + r)$ . For longer loans, interest can itself earn interest. That is compounding, and L1.3.02 builds it up step by step.

Convention

In this lesson every rate is a simple annual rate, and every loan lasts exactly one year, so no day count or compounding is needed.

Worked example

A small business loan in euros

A café in Lisbon borrows €20,000 from its bank for one year at 7% a year, simple interest, repaid in one sum at the end. Expected inflation is 3% a year.

What the loan costs, and what the bank really earns

Step 1 of 4

1
Interest for the year
$I = 20{,}000 \times 0.07 = 1{,}400$ , so €1,400.

The same build-up explains the gap between borrowers. In the illustrative rates above, with 2% expected inflation, the government pays 3.0% and a credit card holder pays 20.0%:

Borrower	Rate	Interest on €1,000 for a year
Government	3.0%	€30
Large company	4.5%	€45
Small business	8.0%	€80
Credit card	20.0%	€200

Regulatory lens

Lenders to consumers must state the cost of credit in a standard form, the annual percentage rate (APR), so borrowers can compare offers. In the US this comes from the Truth in Lending Act; in the EU from the Consumer Credit Directive; in the UK from the FCA's consumer credit rules.

Looking ahead: central banks steer the whole level of rates (L1.2.08), and the rates banks earn and pay return in Module 1.8 when we read a bank's income statement.

Sparks

SparkMost money is made by banks

In 2014 the Bank of England published “Money creation in the modern economy”, explaining that most money in the UK is bank deposits, and that commercial banks create those deposits mainly by lending. Notes and coins are only a small part of the money people use.

SparkWhen the price of credit went below zero

In June 2014 the European Central Bank cut the rate it pays banks on their deposits below zero. Banks were charged for keeping spare money at the central bank. Denmark's central bank had already gone below zero in 2012, and Switzerland, Sweden and Japan followed within two years.

Key takeaways

Money does three jobs: medium of exchange, unit of account and store of value.
Most money is bank deposits. Banks create deposits when they lend, and repayment removes them.
Credit is money now for a promise to repay later; interest is its price.
For one year, interest = principal × rate, and the rate = interest ÷ principal.
A rate pays the lender for waiting, expected inflation, credit risk and costs. Inflation moves all rates; credit risk separates borrowers.

Reaction

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Glossary

Money: Anything widely accepted in payment, which also serves as a measure of value and a way to store it.
Medium of exchange: Money's job as something everyone accepts in payment, so trade does not need barter.
Unit of account: Money's job as a common yardstick for prices, so values can be compared.
Store of value: Money's job as a way to carry spending power from today into the future.
Credit: An arrangement in which one party gets money now and promises to repay it later.
Principal: The amount borrowed, on which interest is charged.
Interest: The amount a borrower pays a lender for the use of money over time.
Interest rate: Interest for one year as a percentage of the amount borrowed.
Inflation: A general rise in prices, which reduces what a unit of money can buy.
Risk premium: Extra return a lender demands for taking on a particular risk.
APR: Annual percentage rate: a standard way of stating the yearly cost of borrowing, including most fees.

Deep Dives & Origins

Deep Dives

McLeay, Radia and Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin, 2014 Q1. Beginner.
Mishkin, The Economics of Money, Banking and Financial Markets, Pearson, the chapters on what money is and on understanding interest rates. Beginner.

Origins

McLeay, M., Radia, A. and Thomas, R., “Money creation in the modern economy”, Bank of England Quarterly Bulletin, 2014 Q1.
Mishkin, F. S., The Economics of Money, Banking and Financial Markets, Pearson.
European Central Bank, monetary policy decisions, press release of 5 June 2014.
US Truth in Lending Act (Regulation Z); EU Consumer Credit Directive.

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