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7.1 Overview of 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 moneyAny asset that serves as a unit of account and can be used as a medium of exchange for economic transactions. It is all assets that have a high degree of liquidity. and the demand for money combine to affect the equilibrium interest rate in an economy. The model is called the money market modelA model showing how the supply of money and the demand for money combine to affect the equilibrium interest rate in an economy..

A country’s money supplyMostly, the amount of coin and currency in circulation and the total value of all checking accounts in banks. 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 operationsRefers to central bank purchases or sales of U.S. government Treasury bonds or bills..”

Money demandRefers to the demand by households, businesses, and the government, for highly liquid assets such as currency and checking account deposits. 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).

Connections

The money market model connects with the foreign exchange (Forex) market because the interest rate in the economy, which is determined in the money market, determines the rate of return on domestic assets. In the Forex market, interest rates are given exogenously, which means they are determined through some process not specified in the model. However, that process of interest rate determination is described in the money market. Economists will sometimes say that once the money market model and Forex model are combined, interest rates have been “endogenized.” In other words, interest rates are now conceived as being determined by more fundamental factors (gross domestic product [GDP] and money supply) that are not given as exogenous.

The money market model also connects with the goods market model in that GDP, which is determined in the goods market, influences money demand and hence the interest rate in the money market model.

Key Takeaway

  • The key results from the money market model are the following:

    • 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 gross domestic product (GDP) rises (falls), the equilibrium interest rate rises (falls).

Exercise

  1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”

    1. The term describing what is mostly composed of coin and currency in circulation and checking account deposits in a country.
    2. The term describing the amount of money that households, businesses, and government want to hold or have available.
    3. Of increase, decrease, or stay the same, this happens to the interest rate when the money supply falls.
    4. Of increase, decrease, or stay the same, this happens to the interest rate when the domestic price level falls.
    5. Of increase, decrease, or stay the same, this happens to the interest rate when real GDP falls.