How Does Money Supply Affect Interest Rates?

You may or may not have heard of the term money supply. This refers to all of the liquid assets and cash that are in circulation in a nation's economy to date. This amount of money is crucial to a country's economic and financial health. Economists and analysts monitor the supply and adjust their monetary and fiscal policies. As such, the money supply has a direct impact on interest rates. In this article, we examine this relationship and what it means for the risk premium.

Key Takeaways

  • The money supply in the United States is influenced by supply and demand and the actions of the Federal Reserve and commercial banks.
  • Interest rates set by the Fed affect the rate that banks borrow from the Fed, interbank borrowing rates, and consumer lending rates.
  • Setting interest rates involves assessing the strength of the economy, inflation, unemployment and supply, and demand.
  • More money flowing through the economy corresponds with lower interest rates, while less money available generates higher rates.
  • Interest rates also reflect risk premium, which is the amount of risk both borrowers and lenders are willing to assume.
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How Does Money Supply Affect Interest Rates?

Money Supply and Interest Rates: An Inverse Relationship

All prices in a market economy are coordinated by supply and demand. Some individuals have a greater demand for present money than their current reserves allow. For instance, most individuals don't have $300,000 lying around to buy a house. To get more present money, these individuals enter the credit market and borrow from those who have an excess of present money. These entities are called savers. Interest rates determine the cost of borrowed money.

The money supply in the United States fluctuates based on the actions of the Federal Reserve and commercial banks. Money supply and interest rates have an inverse relationship. A larger money supply lowers market interest rates, making it less expensive for consumers to borrow.

Conversely, smaller money supplies tend to raise market interest rates, making it pricier for consumers to take out a loan. The current level of liquid money (supply) coordinates with the total demand for liquid money (demand) to help determine interest rates.

In order to set interest rates, the Fed must look at the overall strength of the economy. This includes studying factors like inflation, unemployment, and supply and demand. Once these are determined, the central bank can then decide whether to raise or lower rates. Remember, interest rates have a huge impact on various facets of the economy, including:

  • The lending rate at which commercial banks can borrow from the Fed
  • The lending rate at which commercial banks can borrow money from each other
  • The lending rate set for consumers to borrow from retail banks

0.20%

The current Federal funds rate as of March 2022. This is the rate that banks charge each other for overnight loans and a measure of the economy's health.

Liquidity Preference and Risk Premium

While a nation's money supply plays a big part in the way interest rates are set, it isn't the only thing that affects them. In fact, it works in conjunction with market risk, which also puts pressure on rates. This branches out into two different functions that affect rates significantly. Economists call these dual functions liquidity preference and risk premium.

The Impact of Liquidity Preference

Liquidity preference is a theory that suggests that investors are willing to give up liquidity for higher interest rates. When interest rates are high, investors are happy to put their money into investments with long-term maturity dates. As such, they're willing to give up the possibility of liquidity on securities with short-term maturities because their yields or interest rates are lower.

Let's say a five-year bond has a 2% yield, a 10-year bond has a yield of 4%, and a 30-year bond yields investors 6%. According to the liquidity preference theory, a typical investor may sacrifice the option of liquidity for a higher yield by investing in the 30-year option.

The Impact of Risk Premium

Interest rates aren't only the result of the interaction between the supply and demand for money. They also reflect the level of risk investors and lenders are willing to accept. This is called the risk premium.

Suppose an investor has an excess of present money and is willing to lend or invest the extra cash to someone else over the next two years. There are two possible investments for this present money: one offering a 5% interest rate and the other offering a 6% interest rate.

It's not immediately clear which option the investor should choose because they need to know the likelihood that they'll be paid back. If the 6% seems riskier than the 5%, the investor may choose the lower rate or ask the 6% buyer to raise the rate to a premium commensurate with the assumed risk.

What Is the General Connection Between the Money Supply and Interest Rates?

A nation's money supply and interest rates have an inverse relationship. This means interest rates should be lower if there is a higher supply of money in a country's economy. Conversely, rates should be higher if the money supply is lower.

Why Are the Money Supply and Short Term Interest Rates Inversely Related?

When all else is equal, the inverse relationship between a country's money supply and short-term interest rates make it either more or less expensive for consumers to borrow. So when there is a greater supply of money, interest rates are lower. Therefore, borrowing becomes cheaper. But when the money supply is tighter, interest rates are higher, making debt more expensive to hold.

What Happens to the Money Supply if the Fed Increases Interest Rates?

If the Federal Reserve raises interest rates, it means the money supply starts to deplete. A lower amount of money in the economy makes it more expensive to borrow for banks and consumers.

Does Increasing Interest Rates Increase the Money Supply?

Increasing interest rates does not increase a nation's money supply because the two have an inverse relationship. Higher interest rates translate to a lower supply of money in the economy. Since the supply of money depletes, it raises borrowing costs, which makes it more expensive for consumers to hold debt.

Article Sources
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  1. Federal Reserve Bank of St. Louis. "Effective Federal Funds Rate."

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