Why do interest rates rise when economy is expanding

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Credit available to the economy decreases as lenders decide to defer the repayment of their loans. For instance, when you choose to postpone paying this month's credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market.

This, in turn, will increase the interest rates in the economy. Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they are paid in the future. The government has a say in how interest rates are affected.

The U. Federal Reserve the Fed often makes announcements about how monetary policy will affect interest rates. The federal funds rate , or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend.

That rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with "open market transactions," which is the buying or selling of previously issued U. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease. When the government sells securities, money from the banks is drained for the transaction, rendering fewer funds at the banks' disposal for lending, forcing a rise in interest rates.

Of the factors detailed above, supply and demand are, as we implied earlier, the primary forces behind interest rate levels. The interest rate for each different type of loan, however, depends on the credit risk, time, tax considerations particularly in the U. Risk refers to the likelihood of the loan being repaid. A greater chance that the loan will not be repaid leads to higher interest rate levels. If, however, the loan is "secured," meaning there is some sort of collateral that the lender will acquire in case the loan is not paid back i.

This is because the risk factor is accounted for by the collateral. For government-issued debt securities, there is, of course, minimal risk because the borrower is the government. For this reason, and because the interest is tax-free, the rate on treasury securities tends to be relatively low. Time is also a factor of risk.

Long-term loans have a greater chance of not being repaid because there is more time for the adversity that leads to default. Also, the face value of a long-term loan, compared to that of a short-term loan, is more vulnerable to the effects of inflation.

Therefore, the longer the borrower has to repay the loan, the more interest the lender should receive. Finally, some loans that can be converted back into money quickly will have little if any loss on the principal loaned out. These loans usually carry relatively lower interest rates. The U. But along with this economic success comes the need to alter U. The answer, inflation. Your Practice. Popular Courses.

Part Of. The Federal Reserve. Interest Rates. Monetary Policy. Interest Rate Impact on Consumers. Monetary Policy Federal Reserve.

Table of Contents Expand. Understanding Interest Rates. Looking for Balance. When Interest Rates Go Up. Timing Is Everything. Key Takeaways Central banks set target interest rates for an economy, which becomes the basis for all other interest rates on loans and debts, from car loans and mortgages to complex derivatives like credit default swaps. Economic theory suggests that there is a balance between interest rates, unemployment, and inflation—if rates go too low, the economy can pick up but overheat leading to rising prices.

If rates rise too quickly, by the same token, borrowing becomes more expensive and the economy can grind to a halt. More recent thinking by central bankers has led many to believe that raising rates too quickly is more of a risk than keeping them low for prolonged periods. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.

We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.