3 Reasons Interest Rates Change

Does anyone even know why interest rates change or is it all just a lot of black magic voodoo hocus pocus? Though it might often seem the Federal Reserve chairman is reading tea leaves or scheduling a session with his favorite palm reader, Miss Tessa, to decide where interest rates should go next, the actual reasons they change are pretty straightforward. Here are the Big Three Reasons Interest Rates Fluctuate.

1. Supply and Demand: We like this one. In a pure free market, the demand and availability of funds drives interest rates. Simply put, the interest rate is the price paid for borrowing money. Individuals borrow from banks and banks borrow from other banks, financial institutions and, sometimes, from the government. Our entire economic system is predicated on the idea that you pay a percentage, known as the interest rate, in exchange for the privilege of borrowing money. When borrowers are coming out of the woodwork and demand is high, expect interest rates to rise because fund availability gets low and your bank has to borrow money from another bank in order to continue making loans.

2. Monetary Policy: This is a big one. Governments like to influence the direction of interest rates by undertaking actions that tend to deflate or inflate the cost of borrowing. The primary method of doing this is through printing money. A

n often used term “loosening monetary policy” or fiscal policy simply means that the government has decided to print more money in order to bring interest rates down, which is intended to encourage borrowing and provide a spark to the economy. Sometimes it works. Sometimes it doesn't.

3. Inflation: Inflation devalues money and purchasing power and can have a big effect on interest rates. When inflation is high – the 1970s were a good example, especially during the Carter years – lenders will not usually loan money for anything except very short term unless there is a higher interest rate attached. The higher rate is intended to cover their financial risk at loaning money in an economic environment where inflation could surge even higher, reducing the value of their money even more.

An interesting point for investors everywhere to consider is that, unless you're earning 5% to 10% annually on your investments, there's a good chance you're losing money overall. The reason is that inflation eats away at the value of each and every dollar in your possession at the rate of at least 4% per year.

The American Monetary Association Team

Flickr / Beverly & Pack

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