The history of interest dates back to early civilization. As civilizations moved away from the ‘hunter-gatherer’ ways of their ancestors and moved towards building townships, some chose farming and rearing livestock, some chose helping with infrastructure development, and others chose jobs or vocations that suited them. Thus, instead of being focused on individual needs, they focused on growing and thriving as a community. And this organically gave birth to barter system – exchange of your produce or services for the desired produce or services.
Let us consider an instance where a farmer requires livestock for consumption but does not have anything in hand right then to exchange – say, if his grains are not ready for harvest. And he also requires services from others for such grains to be ready for harvest. This was a common scenario, wherefrom a system was created where such a person could borrow what he requires as and when he needs it, and repay it subsequently. In this case, the farmer would borrow the livestock and services he requires on loan, and on harvest repay the same with his grains, or goods that he receives by selling his grains.
In the Middle Eastern civilizations, there existed the concept of ‘food money’. When seeds or livestock were borrowed for consumption or production, the lender expected to receive more than what was initially lent. This was because such seeds and livestock could produce more food, and the lender was foregoing this opportunity when he lent his produce. Drawing a contemporary parallel – money in hand can be utilized to earn more money. When the same is instead lent, an additional amount, interest, is charged to the borrower.
As civilizations grew and thrived, people began travelling for trade, and businesses flourished. Ergo, borrowing was no longer only for consumption, but also for production. Alongside, the world moved from barter system to currencies, precious metals were used to make coins which was used as currency. However, gold or silver was used in exchange for food grains and livestock, but such metals could not multiply on their own. And therefrom was born interest as is known today.
Then came the industrial revolution in 1760s and much like all else in the field of economics, the concept of interest grew significantly complex. Business grew, and they needed funds to do so. Financial institutes fulfilled this need by moving the money from savers to borrowers. Rates were settled based on the demand and supply of money.
Today, simply put, interest is the cost of using someone else’s money. Economically speaking, an explanation for the interest rate to be more than zero is the scarcity of funds. In a free market, interest rates would have been subject to the laws of demand and supply. However, there are added complexities such as inflation due to which the rates of interest are decided by multiple economic drivers today.