Concept of Interest as compensation for loss of purchasing power due to “inflation”
You keep money in a deposit with a bank. It could be a Savings Bank or a Fixed Deposit. What does the bank pay to you? “Interest”. This is the “return” on your investment. Why should the bank pay interest to you? Let us enumerate the possible reasons for the bank’s action.
¨ The bank does the business of lending. For this, it requires funds through deposits. It earns interest on loans and pays interest on deposits;
¨ With the passage of time, the purchasing power of money reduces. The same thing will happen to your deposit with the bank. The bank gives compensation to you for this loss in value of money;
¨ In case the bank does not pay interest, it will not get funds for lending. You will not keep deposits with it. You will choose other willing banks or avenues of investment.
While all of them are correct, we are more interested in the second reason. Value of money erodes due to “inflation” as we have seen in the earlier paragraph. The rates of inflation would be different for different countries. Further, it could be different for the same country at different times. Sometimes it could be high while at some other times, it could be low.
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