When the money supply increases why do interest rates fall?
Interest rates fall when the money supply increases because the fact of an increased money supply makes it more plentiful. The more plentiful the supply of money, the easier it is for businesses and individuals to get loans from banks.
Interest rates are determined by several factors, most importantly determinations made by the Federal Reserve regarding calculations and projections of inflation. When the Federal Reserve Board wants to reduce the supply of money in the economy as a check on inflationary pressures, it increases the rates that banks charge each other for short-term loans. When it becomes more expensive to borrow money because of higher interest rates, fewer loans are processed.
Over the past year, there has been constant speculation regarding the intentions of the Federal Reserve, with Chairperson Janet Yellen's public appearances monitored closely for indications of whether she will or will not oversee an increase in interest rates. Yellen and her colleagues make their decision based upon informed reasoning that often reflects merely their best guesses of how the economy will perform in the months ahead. If they believe that inflation will increase in the near future, they will raise interest rates so that the supply of money in the economy is tightened.
Money supply refers to the whole amount of money that is circulating in an economy, in the form of currency, coins, notes, money in deposit accounts, and other liquid assets. When money supply increases, the purchasing power of the majority of the population increases, as people have more money to spend. As such, the direct effect is an increased demand for goods and services. Alternatively, because there will be an increase in the amount of money that people can hold, some people will want to keep their excesses in depository institutions. This then encourages these institutions to want to lend more as their money reserves increase, resulting in lowered interest rates. Money supply is determined by the Federal Reserve Bank and other member banks.
Also, as has been explained by other educators, money, like any other commodity, obeys the laws of demand and supply. When depository institutions decrease interest rates, then the cost of accessing loans is reduced. The effect is that more money is in circulation since people are encouraged to take loans out because of the low rates of interest.
Interest rates determine the cost of borrowed money, and the figure fluctuates depending on forces of supply and demand in the market. Thus, when there is an increase in money in the market that means supply increases. In this case, people are motivated to borrow by the financial institutions. In summary, when the supply of money increases, financial institutions drop interest rates to motivate people to borrow.
The opposite situation occurs when there is no money in the market. When money supply in the market decreases, lenders are forced to increase interest rates. In such a situation, lenders respond to the need of controlling the demand and enhancing profitability.
It is important to note that supply and demand are not the only influencers of interest rates. Market risk is another factor that affects interest rates because it determines the willingness of lenders to advance money to borrowers.
The reason for this is that the interest rate is, essentially, the price of money. As you know from basic economics, the price of a good or service is determined by the supply of and demand for that thing. Money is no different.
This means that when the supply of money changes, the price of money will change too (if demand does not change). When the supply of something goes up, its price goes down. When supply goes down price goes up.
The reason behind that is that if there is more money available, lenders cannot charge as much because there is more competition to lend.
We can think of interest rates as the price paid for borrowing money. Thus interest rates also are influenced by the laws of demand and supply. When the money supply increases it means that more money is available in the economy for borrowing and this increased supply, in line with the law of demand tends to reduce the interest rates, or the price for borrowing money down. Similarly when the money supply decreases, it will tend to push up the interest rates.
Of course, supp;u of money is one of the two factors that determine the interest rates. The other factor is the demand for money. This means the demand for borrowing money for investing in business or for consumer purchase on credit. The interest rates tend to increase when demand increases and decrease when demand increases.
The equilibrium rate of interest is the rate at which the demand for money equals the supply of money.