Interest Rate Theories - Interest Rate Variation - Why do interest rates vary?

There is wide variation in interest rates in the UK. The actual interest rate will depend on a number of factors. These include:

• The length of time for which the money is borrowed (or saved)
• The security of the loan (or investment)
• The nature of the financial institution the money is borrowed from (or lent to)
• The amount of competition between financial institutions

If a bank considers a particular loan to be a risky one, and there is little or no security for the loan then it is likely to charge a high rate of interest to compensate it for the risk it is taking. However, where there is security for the loan (as in the case of house purchase) then the interest will be relatively lower to reflect the lower risk.

The interest rate will be set by the equilibrium in the money market. As in other markets, this equilibrium depends on the levels of demand and supply. In the money market, the demand comes from people wanting to borrow and spend, while the supply of money depends on the government's monetary policy. We can see this in the diagram below:

The equilibrium interest rate is at R*. If either the demand or supply of money changes, then this will tend to change the equilibrium interest rate in the markets, and the government may need to act to maintain the level of interest rates.