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What is the Relationship Between Money Supply and Interest Rate?

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  • Written By: Osmand Vitez
  • Edited By: Kristen Osborne
  • Last Modified Date: 18 September 2016
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Macroeconomic theory is the study of various economic factors that include information on aggregated indicators. These factors commonly include a government’s fiscal or monetary policy, which can include information on the money supply and interest rate that drives a market’s liquidity. Money supply refers to how much capital exists in a market that an individual or business can use to engage in financial transactions. Interest rates are the “fees” associated with loans, whether to consumers or between commercial banks. In most economies, a central bank or government agency is responsible for watching over both and adjusting policies as necessary.

Commercial banks play an integral role in the banking system of an economy. They are the primary institutions responsible for accepting customer deposits, making loans to individuals and businesses, and providing other critical financial services. Commercial banks typically operate under a fractional reserve system in which central banks will set a reserve percentage for them. This reserve percentage is the amount of actual cash the bank must have in its coffers at all times. For example, if the central bank sets the reserve percentage at 5% and a bank has customer deposits of $1 million US Dollars (USD), the bank is only required to keep $50,000 USD in its facility (0.05 x 1,000,000).

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Fractional reserve banking affects money supply because the central bank can increase the supply of money by lowering the reserve percentage, say to 4%. This allows individuals and businesses to increase their financial transactions. Raising the reserve percentage will have the opposite effect, removing money from the economy and tightening the money supply.

For the second half of the money supply and interest rate theory, central banks typically set one or two different interest rates in an economy. The first is known as the target interest rate, and banks charge each other this rate when making loans amongst themselves and the central bank. In theory, higher target interest rates mean that banks will have to pay more money on their loans, decreasing the money supply available to consumers.

Central banks can also influence consumer interest rates, which is the amount a bank will charge individuals and businesses for loans. When consumers have to pay more money from higher interest rates, it will reduce the money supply and create a tighter economic market. Raising interest rates is also a common way for the central bank to curb inflation in an economy.

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cupcake15
Post 3

@Sunshine31 -I understand what you are saying and some people feel that the fed interest rates are too low and should be raised in order to balance the economy and get a hold of inflation.

Inflation is definitely beginning to be a problem. I heard in the news the other day that the price of corn went up 30% over last year and there are many products tied to corn which could create a domino effect for consumer goods in general.

sunshine31
Post 2

@Suntan12 - I think that it will take a while for you to notice an impact, but you are smart in trying to pay down your mortgage because they have said that interest rates are at historic lows so they can only go up in the future.

I also heard that the interest rates and money supply are directly related because when the federal government starts to print more money it devalues its currency and has to raise interest rates in order to entice other countries to invest in the debt.

Since we do have a lot of debt as a nation, I am a little concerned about how high the interest rates will go because the housing market is just starting to recover and if interest rates shoot back up there is no telling when the housing market will be back to normal.

suntan12
Post 1

I just wanted to say that I always look at what the Federal Reserve sets interest rates for because I currently have a variable rate mortgage set at .25% above the prime rate. The current prime interest rate today is 3.25% and I am currently paying 3.5% interest.

I am trying to pay down this amount as quickly as possible because I know that there has been an increase in the money supply which will eventually lead to more inflation and eventually higher interest rates.

I was a kid in the 80’s when the federal interest rates were in the double digits and I don’t want it to go to that because it will triple my mortgage payment.

I always cross my fingers when the Fed has an announcement with respect to interest rates and so far since I have gotten my loan I have been lucky as the Fed interest rates have remained stable.

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