Money, Banking, and Financial Markets Practice Test: How Interest Rates Behave — Flashcards

Interest rates are a vital tool of monetary policy that change in response to shifts in the economic climate, especially modifications to the monetary policy. Central banks set interest rates to control the cost of money, ensure monetary stability, and control the rates at which their national currency is traded. They may change interest rates based on economic data such as inflation rates, growth forecasts, and currency rates. 

Interest rates can fluctuate according to the status of the economy. For example, if the economy is strong, interest rates will be high, and if the economy is weak, interest rates will be low. Central banks may increase interest rates if the economy is growing quickly or inflation is too high. 
Interest rates can also reflect inflationary expectations and the credibility of domestic monetary policy. For example, if market participants believe a central bank has set interest rates too low, they may worry about a potential increase in inflation. To compensate for this risk, issuers of long-dated bonds will tend to offer higher interest rates. 

Interest rates can affect debt in a number of ways:
Fixed-rate vs. variable-rate debt: Fixed-rate debt stays the same, and you pay the same monthly amount. Variable-rate debts come with possible payment increases.
Secured vs. unsecured debt: For example, auto loans are secured, and credit cards are unsecured. 

Related Test: Money, Banking, and Financial Markets Practice Test: The Basics of Interest Rates