What is the Relationship Between Money Supply and Interest Rate?

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).

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.