Why do interest rates change?

By Daniel Kurt AAA
A:

Interest is simply the cost of borrowing money. As with any good or service in a free market economy, price ultimately boils down to supply and demand. When demand is weak, lenders charge less to part with their cash; when demand is strong, they're able to boost the fee. Demand for loans ebbs and flows with the business cycle. During a recession, fewer people are looking for new mortgages or loans for their start-up businesses. Eager to increase lending, banks put their money "on sale" by dropping the rate.

Supply also changes as economic conditions fluctuate. In this regard, the government plays a major role. 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.

It's important to note that short-term loans and long-term loans can be affected by very different factors. For instance, the buying and selling of 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 an important factor. If consumers fear the value of their money will rapidly decline, they'll demand a higher rate on their "loan" to the government.

RELATED FAQS

  1. How does money supply affect inflation?

    Learn about two competing economic theories of the role of the money supply and whether money supply necessarily causes inflation ...
  2. How were bonds and derivatives manipulated in the LIBOR scandal of 2012?

    Discover what happened with the LIBOR scandal, uncovered in 2012, why it was important, and proposals to prevent it from ...
  3. How can industrialization affect the national economy of less developed countries ...

    Read about how industrialization impacts economic growth in less developed countries (LDCs), using Hong Kong and Great Britain ...
  4. What is the difference between consumer surplus and economic surplus?

    Learn the difference between consumer surplus and economic surplus, how the concepts are related and the important theoretical ...
RELATED TERMS
  1. Deflationary Spiral

    A deflationary spiral is when a period of decreasing prices (deflation) ...
  2. Negative Interest Rate Policy (NIRP)

    A negative interest rate policy (NIRP) is an unconventional monetary ...
  3. Nordic Model

    The social welfare and economic systems adopted by Nordic countries.
  4. Fee Harvesting Card

    Credit cards targeted at consumers with poor credit scores that ...
  5. Zero Percent

    A promotional rate of interest used to entice consumers, often ...
  6. Penalty Repricing

    An increase in a credit card’s interest rate that occurs when ...

You May Also Like

Related Articles
  1. Economics

    Gambling on Macau: Too Risky?

  2. Mutual Funds & ETFs

    GLD vs. IAU: Which Gold ETF is Better?

  3. Options & Futures

    Why Gold's Price is More than 'Supply ...

  4. Stock Analysis

    How Two Harbors' Derivatives Work?

  5. Stock Analysis

    Is Prospect Capital Exposed To Elevated ...

Trading Center