Interest Rate Determination

Key Takeaways

• If the actual interest rate is lower than the equilibrium rate, the amount of assets people are holding in a liquid form is less than the amount they would like to hold. They respond by converting assets from interest-bearing nonmoney deposits into money. The decrease in loanable funds will cause banks to raise interest rates. Interest rates rise until money supply equals money demand.
• If the actual interest rate is higher than the equilibrium rate, the amount of assets people are holding in a liquid form is greater than the amount they would like to be holding. They respond by converting assets from money into interest-bearing nonmoney deposits. The increase in loanable funds will cause banks to lower interest rates. Interest rates fall until money supply equals money demand.