Interest is the cost of borrowing money. Borrowing money enables you to acquire goods and services that will produce value. Lending \100$100$100$ makes poorer, reducing your ability to acquire goods and services that will produce value, hence you want to be compensated for more than you have lent. ‘Interest’ literally means ‘compensation for loss’ from the Latin word ‘interesse’.
When you make a deposit of \100$100$ with the expectation of being paid a certain interest rate for letting the bank do what it wants with you money. Note that although private banks each set their own interest rates on savings accounts and on loans, they’re all directly influenced by the interest rate set by the central bank.
Remember, the economy is not a zero-sum game. In theory, the act of lending/borrowing should result in a win-win scenario and create a net increase in ‘value’ in the game (economy). The economic pie tends to keep on growing.
Fundamentally, the concept of interest exists because all humans value something more when they can use it today versus tomorrow because life is finite.
Interestingly, the Islamic banking system prohibits monetary interest for religious reasons, instead it sets up other non-monetary incentive structures to reward lenders.
Nominal vs. Real Interest
Nominal interest rate — the monetary interest charged on a loan. It does not take into account the effects of inflation.
Real interest rate — the interest charged on loan adjusted for inflation. The real interest rate can be approximated by the difference between the nominal interest rate and inflation rate: , where is nominal interest rate and is the inflation rate over the period of the loan (eg. 1 year).
If you’re a lender and want to earn a real interest rate of 5%, for example, and you’re expecting the inflation rate to be 2%, then you should set the nominal interest rate to be 7%.
Fisher Effect
The Fisher Effect asserts that nominal interest rate will increase 1:1 with inflation, ie. that every 1% rise in inflation will have a corresponding 1% rise in nominal interest rate.