Interest Rate Determination

Learning Objective

1. Learn how a money market model, combining money supply and demand, influences the equilibrium interest rate in an economy.

This chapter describes how the supply of money and the demand for money combine to affect the equilibrium interest rate in an economy. The model is called the money market model.

A country's money supply is mostly the amount of coin and currency in circulation and the total value of all checking accounts in banks. These two types of assets are the most liquid (i.e., most easily used to buy goods and services). The amount of money available to spend in an economy is mostly determined by the country's central bank. The bank can control the total amount of money in circulation by using several levers (or tools), the most important of which is the sale or purchase of U.S. government Treasury bonds. Central bank sales or purchases of Treasury bonds are called "open market operations".

Money demand refers to the demand by households, businesses, and the government, for highly liquid assets such as currency and checking account deposits. Money demand is affected by the desire to buy things soon, but it is also affected by the opportunity cost of holding money. The opportunity cost is the interest earnings one gives up on other assets to hold money.

If interest rates rise, households and businesses will likely allocate more of their asset holdings into interest-bearing accounts (these are usually not classified as money) and will hold less in the form of money. Since interest-bearing deposits are the primary source of funds used to lend in the financial sector, changes in total money demand affect the supply of loanable funds and in turn affect the interest rates on loans.

Money supply and money demand will equalize only at one average interest rate. Also, at this interest rate, the supply of loanable funds financial institutions wish to lend equalizes the amount that borrowers wish to borrow. Thus the equilibrium interest rate in the economy is the rate that equalizes money supply and money demand.

Using the money market model, several important relationships between key economic variables are shown:

• When the money supply rises (falls), the equilibrium interest rate falls (rises).
• When the price level increases (decreases), the equilibrium interest rate rises (falls).
• When real GDP rises (falls), the equilibrium interest rate rises (falls).