Definition
The interest rate is the price paid for the use of borrowed capital, expressed as a percentage of the amount borrowed per year. In Adam Smith's framework, interest is a share of the profit the borrower expects to earn by employing the capital — bounded above by the profit rate (no one will pay more in interest than they expect to earn) and bounded below by the lender's opportunity cost.
What is actually lent, Smith insists, is real capital — the power to command goods, materials, and wage advances — even though the transfer takes the form of money. Confusing the supply of money with the supply of capital is a recurring mercantilist error he sets out to correct.
Why it matters
How it works
In the simplest case, a lender has saved capital they do not wish to employ themselves. A borrower has a productive use for capital they do not own. The interest rate is the price that brings the two together — high enough to compensate the lender for forgone alternatives, low enough that the borrower can earn it back plus a margin from the productive use.
Smith's key observation: the interest rate tracks the profit rate. If profits in the economy generally yield 12%, lenders will demand something like 6-8% interest on safe loans (Smith estimates roughly half the profit rate). As profits fall (due to capital accumulation, see Topic 9), interest rates fall in step. England's legal interest rate fell from 10% (1545) to 5% (1714) as the country's capital stock deepened — a direct reflection of falling profit rates.
The rate is also a signal of the borrower's risk profile and of the lender's own cost of capital. A loan offered well below the market rate is suspicious (subsidised, mispriced, or hides bad terms). A loan offered well above the market rate signals either that the borrower is risky or that the lender's funding is expensive.
Usury laws and price ceilings
Smith's discussion of legal limits on interest is famously ambivalent. He concedes the case for a moderate ceiling — slightly above the market rate — to prevent extortion of borrowers in desperate situations. But he warns that a ceiling set well below the market rate harms the credit system:
- Prudent productive borrowers will not break the law for credit; they refuse the loan.
- Reckless borrowers (the only ones willing to evade the law) take whatever capital is illegally available.
- Capital is therefore reallocated toward the riskiest borrowers and away from the productive ones.
This is the conceptual root of the modern observation that price ceilings on credit do not give borrowers cheap credit — they reallocate credit. The empirical literature on payday lending caps, microfinance regulation, and credit-card APR caps confirms the pattern.
Modern descendants
Modern monetary policy and credit regulation both rest on Smith's framework:
- Central banks set short-term interest rates not because money is scarce but because the price of capital coordinates real investment decisions.
- Inflation targeting rests on the principle that interest rates clear the market for real capital; mispricing them produces inflation or deflation.
- Yield curves track the term structure of interest rates and embed market expectations about future capital scarcity.
- The 2008 crisis and the 2021-2024 inflation cycle can both be read as case studies in the consequences of interest rates held below their natural level — capital flowing toward marginal opportunities, then being destroyed when rates normalise.
- Personal finance — the interest rate on your savings, your mortgage, your credit card all encode information about your situation and the broader cost of capital.
The term structure and the yield curve
There is no single "the interest rate" in a modern economy. There is a structure of rates that varies by maturity (short- vs. long-term), credit quality (risk-free government debt vs. corporate or personal debt), and liquidity. The central bank directly controls only the shortest-term rate — the overnight interbank rate — but that rate anchors the entire structure through arbitrage and expectations.
Real vs. nominal rates
The Fisher equation
Smith's "interest rate" is, in modern terms, a nominal rate. The Fisher equation decomposes it into its components:
Nominal rate ≈ Real rate + Expected inflation
A 6% nominal mortgage rate during a period of 4% expected inflation yields a real rate of only 2% — the actual gain in purchasing power the lender earns. This matters because borrowers and lenders both care about real rates; central banks set nominal rates but target real economic outcomes; and inflation surprises redistribute wealth (unexpected inflation benefits borrowers, unexpected deflation benefits lenders).
The zero lower bound
Central banks can cut the nominal rate to near zero but not far below it (slightly negative rates are possible but distort the banking system). At the zero lower bound, conventional policy loses traction, and central banks resort to unconventional tools: quantitative easing (buying long-term assets to push down long-term rates), forward guidance (committing to future low rates), and yield-curve control (capping specific maturities).