How and why do interest rates increase?
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When we talk about “interest rate rises” we’re usually talking about the rate charged by central banks (eg. the Bank of England, European Central Bank, US Federal Reserve). This is often called the “base rate”.
This is linked to the rates charged and offered by other banks and lending institutions, but it’s not the only factor. Rates on mortgages, for example, can go up or down for other reasons, such as the availability of funds or the risk of people not paying.
Back to the central bank though. When they lend money, commercial banks have to borrow money from the central bank. If the central bank’s interest rate goes up, lending becomes more expensive for commercial banks. They then increase their interest rates to cover the cost.
This has a number of economic effects.
Lower interest rates encourage borrowing. They tend to encourage economic growth, and they make things easier for existing borrowers.
Higher interest rates attract money from other countries. If I’m trying to decide whether to hold my money in pounds sterling or dollars, one of the things I’ll consider is where I’ll get the best interest rate. This tends to push up the value of the currency, making imports cheaper and exports more expensive, and lowering inflation.
High interest rates also reduce the amount of money in circulation *edit: or more likely, slow its growth*. This is because commercial banks create money when they make loans. The higher the cost of taking out a loan, the less people will borrow, and thus the less money is created. This tends to reduce inflation.
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