Why Do Interest Rates Change?

Interest rates fluctuate due to a range of factors, including supply and demand of credit and government policy. When there is high demand for money, lending institutions like banks can set higher interest rates on loans, making it more expensive to borrow. Conversely, when demand is low, interest rates will typically fall instead. The government can also influence interest rates, such as by changing the federal funds rate, which determines the target interest rate at which commercial banks loan to one another.

Key Takeaways

  • A range of different factors influence the rise and fall of interest rates.
  • In general, supply and demand play a significant role in determining interest rates.
  • When there is high demand for money, lending institutions will typically raise interest rates, effectively charging more for loans.
  • Monetary policy can also play a role in raising or lowering interest rates, particularly during economic downturns or periods of rapid inflation.

Why Do Interest Rates Fluctuate?

In simple terms, interest is the cost of borrowing money. As with any good or service in a free market economy, this cost is greatly affected by supply and demand. When demand for money is weak, lenders charge less to part with their cash, resulting in lower interest rates. Conversely, when demand for money is strong, lenders can boost interest rates. In effect, they can charge more to borrowers for loans.

Demand for financing ebbs and flows with the business cycle. During a recession, for instance, fewer people buy cars or houses or seek financing to start or grow businesses. Consequently, demand for loans, including auto loans or new mortgages, will be lower during such periods. Eager to increase lending, banks may put their money “on sale” by dropping the interest rate.

How Does the Government Influence Interest Rates?

The government can also influence interest rates through monetary policy. For example, central banks like the United States Federal Reserve tend to buy government debt during a downturn, pumping the stagnant economy with cash that can be used for new loans. The increase in supply, combined with diminished demand, forces rates downward. The exact opposite occurs during an economic boom.

Another way that the Federal Reserve can influence interest rates is by adjusting the federal funds rate, which is the target interest rate at which banks borrow and lend to each other overnight. This rate can affect the rates that banks charge their customers.

It’s important to note that very different factors can affect short-term and long-term loans. For instance, the buying and selling securities by a central bank has a much greater impact on near-term lending, such as credit card rates and car loans. For lengthier notes, such as a 30-year Treasury bond, the prospects for inflation can be influential. If consumers fear that the value of their money will rapidly decline, for instance, they may demand a higher interest rate on their “loan” to the government.?

Do Interest Rates Go Up During a Recession?

Interest rates typically fall during a recession. This is partly because demand for loans weakens in times when consumers save more and spend less. Companies and investors are usually more conservative during such periods and may delay taking on loans to start or expand businesses.

Who Benefits From Higher Interest Rates?

Lending institutions like banks or brokerage firms generally benefit when interest rates rise, as it becomes more profitable to loan money.

Does Inflation Affect Interest Rates?

Inflation can also affect interest rates. Central banks like the Federal Reserve seek to keep inflation steady. When inflation is rapid, the Federal Reserve typically increases interest rates. This raises the cost of borrowing money and encourages consumers to spend less and save more, cooling the economy.

Bottom line

Interest rates fluctuate in response to various factors. Primarily, they are influenced by supply and demand. When there's a strong demand for money or credit, lending institutions can increase the cost of borrowing. When demand weakens, they can reduce interest rates, making it cheaper to take on loans. In addition to supply and demand, government monetary policy can also affect interest rates in the short- and long-term.

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