How Money Supply and Demand Determine Nominal Interest Rates

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Using Money Supply and Demand to Determine Nominal Interest Rates

The nominal interest rate is the rate of interest before adjusting for inflation. Learn how money supply and money demand come together to determine nominal interest rates in an economy. These explanations are also accompanied by relevant graphs that will help illustrate these economic transactions.

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Nominal Interest Rates and the Market for Money

Like many economic variables in a reasonably free-market economy, interest rates are determined by the forces of supply and demand. Specifically, nominal interest rates, which is the monetary return on saving, is determined by the supply and demand of money in an economy. 

Obviously, there is more than one interest rate in an economy and even more than one interest rate on government-issued securities. These interest rates tend to move in tandem, so it is possible to analyze what happens to interest rates overall by looking at one representative interest rate.

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What Is the Price of Money?

Like other supply and demand diagrams, the supply and demand for money is plotted with the price of money on the vertical axis and the quantity of money in the economy on the horizontal axis. But what is the "price" of money? 

As it turns out, the price of money is the opportunity cost of holding money. Since cash doesn't earn interest, people give up the interest that they would have earned on non-cash savings when they choose to keep their wealth in cash instead. Therefore, the opportunity cost of money, and, as a result, the price of money, is the nominal interest rate.

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Graphing the Supply of Money

The supply of money is pretty easy to describe graphically. It is set at the discretion of the Federal Reserve, more colloquially called the Fed, and is thus not directly affected by interest rates. The Fed may choose to alter the money supply because it wants to change the nominal interest rate.

Therefore, the supply of money is represented by a vertical line at the quantity of money that the Fed decides to put out into the public realm. When the Fed increases the money supply, this line shifts to the right. Similarly, when the Fed decreases the money supply, this line shifts to the left.

As a reminder, the Fed generally controls the supply of money by open-market operations where it buys and sells government bonds. When it buys bonds, the economy gets the cash that the Fed used for the purchase, and the money supply increases. When it sells bonds, it takes in money as payment and the money supply decreases. In fact, even quantitative easing is just a variant on this process.

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Graphing the Demand for Money

The demand for money, on the other hand, is a bit more complicated. To understand it, it's helpful to think about why households and institutions hold money, i.e. cash.

Most importantly, households, businesses and so on use money in order to purchase goods and services. Therefore, the higher the dollar value of aggregate output, meaning the nominal GDP, the more money the players in the economy want to hold in order to spend it on this output.

However, there's an opportunity cost of holding money since money doesn't earn interest. As the interest rate increases, this opportunity cost increases, and the quantity of money demanded decreases as a result. To visualize this process, just imagine a world with a 1,000 percent interest rate where people make transfers to their checking accounts or go to the ATM every day rather than hold any more cash than they need to.

Since the demand for money is graphed as the relationship between the interest rate and quantity of money demanded, the negative relationship between the opportunity cost of money and the quantity of money that people and businesses want to hold explains why the demand for money slopes downward.

Just like with other demand curves, the demand for money shows the relationship between the nominal interest rate and the quantity of money with all other factors held constant, or ceteris paribus. Therefore, changes to other factors that affect the demand for money shift the entire demand curve. Since the demand for money changes when nominal GDP changes, the demand curve for money shifts when prices (P) and/or real GDP (Y) changes. When nominal GDP decreases, the demand for money shifts to the left, and, when nominal GDP increases, the demand for money shifts to the right.

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Equilibrium in the Money Market

As in other markets, the equilibrium price and quantity is found at the intersection of the supply and demand curves. In this graph, the supply of and demand for money come together to determine the nominal interest rate in an economy.

Equilibrium in a market is found where the quantity supplied equals the quantity demanded because surpluses (situations where supply exceeds demand) pushes prices down and shortages (situations where demand exceeds supply) drive prices up. So, the stable price is the one where there is neither a shortage nor a surplus.

In terms of the money market, the interest rate must adjust such that people are willing to hold all of the money that the Federal Reserve is trying to put out into the economy and people aren't clamoring to hold more money than is available. 

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Changes in the Supply of Money

When the Federal Reserve adjusts the supply of money in an economy, the nominal interest rate changes as a result. When the Fed increases the money supply, there is a surplus of money at the prevailing interest rate. In order to get players in the economy to be willing to hold the extra money, the interest rate must decrease. This is what is shown in the left-hand side of the diagram above.

When the Fed decreases the money supply, there is a shortage of money at the prevailing interest rate. Therefore, the interest rate must increase in order to dissuade some people from holding money. This is shown in the right-hand side of the diagram above.

This is what is actually happens when the media says that the Federal Reserve raises or lowers interest rates- the Fed isn't directly mandating what interest rates are going to be but is instead adjusting the money supply in order to move the resulting equilibrium interest rate.

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Changes in the Demand for Money

Changes in the demand for money can also affect the nominal interest rate in an economy. As shown in the left-hand panel of this diagram, an increase in the demand for money initially creates a shortage of money and ultimately increases the nominal interest rate. In practice, this means that interest rates increase when the dollar value of aggregate output and expenditure increases.

The right-hand panel of the diagram shows the effect of a decrease in demand for money. When not as much money is needed in order to purchase goods and services, a surplus of money results and interest rates must decrease in order to make players in the economy willing to hold the money.

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Using Changes in the Money Supply to Stabilize the Economy

In a growing economy, having a money supply that increases over time can actually have a stabilizing effect on the economy. Growth in real output (i.e. real GDP) will increase the demand for money, and will result in an increase in the nominal interest rate if the money supply is held constant.

On the other hand, if the supply of money increases in tandem with the demand for money, the Fed can help to stabilize nominal interest rates and related quantities (including inflation).

That said, increasing the money supply in response to a demand increase that is caused by an increase in prices rather than an increase in output is not advisable, since that would likely exacerbate the problem of inflation rather than have a stabilizing effect.