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All else being equal, a larger money supply lowers market interest rates. Conversely, smaller money supplies tend to raise market interest rates. The current level of liquid money (supply) coordinates with the total demand for liquid money (demand) to help determine interest rates.

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

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

However, market risk is another pressure on interest rates that influences them in a significant way. Economists call these dual functions "liquidity preference" and "risk premium."

Interest Rates Are Also Affected by Risk Premiuim

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 the risk premium.

Suppose an investor has excess present money and he's willing to lend or invest the extra cash over the next two years. There are two possible investments for his present money—one offering a 5% interest rate and the other offering a 6% interest rate.

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

(For related reading, see: Forces Behind Interest Rates.)

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