How does the money supply affect interest rates?

All other things being equal, a larger money supply lowers market interest rates, making borrowing less expensive for consumers. Conversely, a lower money supply tends to increase market interest rates, making it more expensive for consumers to take out a loan. The current level of cash (supply) coordinates with the total demand for cash (demand) to help determine interest rates.

Key points to remember

  • In the United States, money supply is influenced by supply and demand, as well as the actions of the Federal Reserve and commercial banks.
  • The Federal Reserve sets interest rates, which determine what banks get paid to borrow money, what the Fed charges banks to borrow money from, and what consumers pay to borrow money. money.
  • Setting interest rates involves assessing the strength of the economy, inflation, unemployment, supply and demand.
  • More money circulating in the economy corresponds to lower interest rates, while less available money generates higher rates.
  • Interest rates also reflect the risk premium, which is the level of risk borrowers and lenders are willing to take.

More money available, lower interest rate

In a market economy, all prices, even the prices of the current currency, are coordinated by supply and demand. Some individuals have a greater demand for current money than their current reserves allow; most home buyers don’t have $ 300,000 lying around, for example. To get more cash present, these individuals enter the credit market and borrow from those who have excess cash present (savers). Interest rates determine the cost of the current money borrowed.

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The current federal funds rate, as of October 2020, is the rate banks charge each other for overnight loans and a measure of the health of the economy.

The money supply in the United States fluctuates based on the actions of the Federal Reserve and commercial banks. According to the law of supply, the interest rates charged for borrowing money tend to be lower when there is more.

However, market risk is another pressure on interest rates that influences them significantly. Economists call these dual functions “liquidity preference” and “risk premium”.

How does the money supply affect interest rates?

The impact of the risk premium

Interest rates are not only the result of the interplay between money supply and demand; they also reflect the level of risk that investors and lenders are prepared to accept. This is the risk premium.

Suppose an investor has excess money present and is ready to lend or invest the additional money over the next two years. There are two possible investments for your current money: one offering an interest rate of 5% and the other offering an interest rate of 6%.

It is not immediately clear what he should choose, as he needs to know the likelihood of his being reimbursed. If the 6% seems riskier to him than the 5%, he can choose the lowest rate or ask the buyer of the 6% to increase his rate at a premium proportionate to the risk assumed.

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