Table of Contents

How Does Money Supply Affect Interest Rates?

By

Sean Ross

Updated June 19, 2024

Reviewed by

Michael J Boyle

Fact checked by

Daniel Rathburn

Part of the Series

How The Fed’s Interest Rates Affect Consumers

The Federal Reserve

Interest Rates

Monetary Policy

Interest Rate Impact on Consumers

Interest Rate Ripple Effects on Markets

The term money supply refers to all the liquid assets and cash that are in circulation in a nation's economy. 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 so the money supply has a direct impact on interest rates.

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 as well as 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. Less money available generates higher rates.
Interest rates also reflect risk premium: the amount of risk that both borrowers and lenders are willing to assume.

U.S. Treasury Building — SAUL LOEB / Contributor / Getty Images

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.

Most individuals don't have $300,000 lying around to buy a house. These individuals enter the credit market and borrow from those who have an excess of present money. These entities are referred to as 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. The current level of liquid money or supply coordinates with the total demand for liquid money or demand to help determine interest rates.

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. Smaller money supplies tend to raise market interest rates, making it pricier for consumers to take out a loan.

The Fed must look at the overall strength of the economy to set interest rates. This includes studying factors like inflation, unemployment, and supply and demand. The central bank can then decide whether to raise or lower rates when these are determined.

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

5.33%

The Federal funds rate was 5.33% as of May 2024. This is the rate that banks charge each other for overnight loans. It's a measure of the economy's health.

Liquidity Preference and Risk Premium

A nation's money supply plays a big part in the way interest rates are set but it isn't the only thing that affects them. Money supply works in conjunction with market risk which also puts pressure on rates. This branches out into two functions that significantly affect rates. Economists refer to these dual functions as 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. Investors are happy to put their money into investments with long-term maturity dates when interest rates are high. 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 that 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%. A typical investor may sacrifice the option of liquidity for a higher yield by investing in the 30-year option according to the liquidity preference theory.

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 that investors and lenders are willing to accept. This is referred to as the risk premium.

Suppose an investor has an excess of present money and is willing to lend or invest the extra cash to someone 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 must consider the likelihood that they'll be repaid. The investor might choose the lower rate or ask the 6% buyer to raise the rate to a premium in proportion to the assumed risk if the 6% seems riskier than the 5%.

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

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

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

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

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

The money supply begins to deplete if the Federal Reserve raises interest rates. A lower amount of money in the economy makes it more expensive for banks and consumers to borrow.

Does Increasing Interest Rates Increase the Money Supply?

Increasing interest rates doesn't 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. The supply of money depletes so it raises borrowing costs and this makes it more expensive for consumers to hold debt.

The Bottom Line

Money supply refers to all liquid assets and cash in a country’s economy. It has a strong effect on the nation and consumers as well so the Federal Reserve regularly monitors and attempts to influence it. One tool the Fed uses involves setting interest rates and this can have a direct effect on you as a consumer. A greater money supply drops interest rates. Less money generates higher rates.

Article Sources

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Khan Academy. "Money Supply and Demand Impacting Interest Rates." Download transcript.
Federal Reserve Bank of St. Louis. "Effective Federal Funds Rate."
Economicshelp.org. "Increasing the Money Supply."