Economists have often noticed that as an economy recovers from a recession, interest rates start to rise. And, in general, interest rates tend to rise as the economy grows quickly. An example occurred during 2005, when interest rates on three-month Treasury bills rose from 2.3 percent at the beginning of the year to 3.9 percent at the end of the year, as real GDP grew very rapidly.
Some observers think this is puzzling because they associate higher interest rates with lower output. Why should a recovery be associated with higher interest rates? The simple model of the money market helps explain why interest rates can rise during an economic recovery. One key to understanding this phenomenon is that the extra income being generated by firms and individuals during the recovery will increase the demand for money. Because the demand for money increases while the supply of money remains fixed, interest rates rise.
Another factor is that the Federal Reserve itself may want to raise interest rates as the economy grows rapidly to avoid overheating the economy. In this case, the Fed cuts back on the supply of money to raise interest rates. In both cases, however, the public should expect rising interest rates during a period of economic recovery and rapid GDP growth.