Money Demand and Interest Rates

Money Demand and Interest Rates

Introduction

As the price of the product in a market is determined by its demand and supply, the equilibrium price is set where the quantity demanded for the product is equals to the supply of that product. Similarly the interest rate in an economy is determined by the supply and demand for money. It is important to analyze what determines interest rates that prevail in the economy. The force of demand for money coupled with the supply of money tends to determine the interest rate. The point at which demand and supply of money intersects is the equilibrium interest rate. Federal government plays a key role in controlling the money that is circulated in the economy, money is used by public to purchase commodities that undertakes; consumption expenditure, investment expenditure, government purchases and net exports, these altogether form the aggregate expenditure of an economy. As the circulation of money in an economy increases there is an increase in the aggregate expenditure as it increases the purchasing power of all four sectors those are, household, business government and foreign, and a decrease in money circulation causes aggregate expenditure to fall (Lewis, 2011).

Interest rates can be defined as a measure of cost of borrowing money, and thus have an impact over the aggregate demand. However the changes in interest rates are caused by changes in demand and supply of money. Quantity demanded for money and interest rates have and inverse relationship and increase in the and increase in interest rates causes the quantity demanded for money to decline as the cost of borrowing money now increases and consumers tend to save more than their spending and consumption. Companies finance their business operations by borrowing money from banks, however if interest rates will increase it will again result in rise in the cost of borrowing thus this leads to a decline in investment and consequently a fall in demand for money (Boyes & Melvin, 2012). Whereas if there is a fall in the interest rates the quantity demanded for money will increase since people will now be reluctant to save and will borrow more money at lower cost businesses will also be able to get money at lower cost and therefore an increase in investment will increase the quantity demanded for money, the opportunity cost of holding money decreases as interest fall, people want to earn interest on their savings and when the interest rate is low they do not save and tend to consume more (Hall, Swamy & Friedman, 2012). The supply of money however does not depend on interest rates, therefore it is considered to be constant and shown by a vertical curve as illustrated in the diagram below denoted with MS and demand curve for money as MD showing the inverse relationship between quantity demanded for money (MD) on the horizontal axis and interest rates (i) on the vertical axis.

Equilibrium Interest Rate

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Discussion

Money and bonds can be classified as two ...