 There are concerns that the drop in share prices could be severe |
There are concerns that higher rates will hit corporate profits and takeover deals, and dent consumer spending.
European markets were also jittery, with London's share index closing down for a fourth day and ending at its lowest level since the middle of March.
Analysts have warned that markets could remain volatile for a number of weeks.
"I think you've got bargain hunters out there for sure and I think you've got some people who are still scared," said Randy Frederic of Charles Schwab & Co.
"We're seeing the convergence of a whole host of sort of unrelated or only slightly related issues," he explained.
Share fall
By the close of trading in New York, the Dow Jones Industrial Average of leading shares was 208.1 points, or 1.5%, lower at 13,265.47.
Since Monday the index has lost 4.2%, its worst weekly decline in almost five years.
The wider measure of the US stock market, the S&P 500, ended down 1.6%, while the Nasdaq index, which largely tracks technology stocks, was 1.4% lower.
The stock market as a whole may be set for some dismal days 
BBC Business Editor
Earlier, the FTSE 100 index of leading shares on the London market had closed 36 points, or 0.6%, lower at 6215.20. France's Cac-40 index of leading shares and Germany's Dax also declined.
In Asia, the Wall Street slump on Thursday led to Japan's Nikkei closing down 418.28 points, or 2.4%, at 17,283.81, while Hong Kong's index ended 2.7% lower.
Credit crunch
The main underlying problem is that many investors are worried about an impending credit crunch.
In past years, financial markets, companies and consumers have all benefited from low interest rates and easy access to money, helping fuel a boom in spending, house price inflation and corporate takeovers.
When there's uncertainty about financing, then private equity is not so quick to make deals
Now, interest rates are rising and set to stay higher as central banks try to rein in inflation.
A large part of the rise in share prices in the past year has been driven by the takeover boom, with private equity bidders pushing up the value of the firms they are targeting.
Most of these deals are paid for with borrowed money and the banks who have loaned this cash have been laying off a large proportion of the loans by selling them to other investors.
However because investors are bruised by their losses in the US sub-prime mortgage market, they are now less keen now on buying the risky loans from the banks, taking away the credit needed for takeovers and prompting share prices to fall.
"When there's uncertainty about financing, then private equity is not so quick to make deals," said Elliot Spar of Ryan Beck & Co.
Fred Dickson of D.A Davidson & Co said that: "We've had this massive change in investor expectations in terms of new deal flow."
"The lifeguards have shouted, and investors are now starting to heed their warnings and head back to shore."
Downhill track
At the same time, oil prices have climbed, raising fears that inflation could also pick up again because of higher energy costs.
US markets bounced back slightly on Friday after figures showed that the US economy had grown more quickly in three months to June than analysts had first thought.
US Commerce department data showed that, on an annual basis, the US economy grew by a robust 3.4% in the second quarter of 2007.
However, the respite was short-lived as analysts fretted that the figures may increase the chances of further interest rate rises in the US.
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