Interest rates are affected primarily by economic conditions and the rate of inflation. Governments, or other designated bodies, have the power to raise or lower interest rates and usually do so to regulate the financial and economic markets. It is a blunt tool used to try and stabilise the main economic indicators and maintain the economy on an even keel.
When economic growth is vigorous, this can lead to inflation. People have money to spend and manufacturers and retailers feel able to increase prices and increase the margins on their products or services. The economy looks good and everyone is happy. However, if inflation is too high it can lead to difficulties with the economy, such as the value of savings decreasing in real terms and the cost of borrowing may become high. The financial regulator of the economy, be it a central bank or Government department, will want to bring inflation under control and will attempt to do this by raising interest rates.
Raising interest rates has the effect of removing money from the economy as the cost of borrowing increases. Anyone with a mortgage will feel this keenly almost immediately. People and organisations have less disposable income (more being spent on loan repayments) and will feel poorer. This has the affect of slowing economic growth and acts as a dampener on inflation. People are less inclined to spend money and when they do, they are more careful to try and find a bargain. Organisations have to start looking carefully at their pricing strategy in order to maintain customers and make a profit. Prices rises slow, and in fact in some areas may even decrease. Inflation, therefore, decreases and the economic cycle is set to start again. At least in theory, in reality there are a whole range of other factors which impinge.
Conversely, if the economy is weakening, the economic regulator may want to stimulate spending by reducing interest rates. This puts money into the economy, as loans become cheaper and people feel richer. If people have more money and are spending more, the economy is stimulated and economic growth follows. As before, organisations feel able to increase their prices, people have money to spend and so pay the higher prices, until inflation becomes too high again. Then the cycle of pulling the interest rate lever begins again.