MONEY SUPPLY AND ITS EFFECTS ON INTEREST RATES
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Where does money come from? Who supplies it? The answers to those
questions help to explain how interest rates are determined. The Treasury prints
the money. However, the Federal Reserve is in charge of regulating the amount of
money circulating in our economy. If the Federal Reserve believes there is too
much money in circulation, it will take some out.
control of the money supply is called monetary policy.
Essentially, interest rates are determined by the supply and
demand of money. Monetary policy controls the supply of money in our economy. If
there is an oversupply of money in the economy, money becomes relatively easy to
come by, and interest rates tend to fall as a result. If money is scarce,
interest rates will rise due to the shortage of available funds.
When people save their money, it increases the amount of capital
available to lend.
of income that people save is called the savings rate.
The higher the savings rate, the more money that is available for
loans. An increase in the supply of capital will lead to lower interest rates,
if all other factors remain the same. However, if interest rates fall too low,
investors lose incentive to save. If this occurs, interest rates will start to
increase again to stimulate saving.
Both monetary policy and the savings rate determine the
supply of money available for borrowing. You can think of interest rates as the
price of money. When there is an oversupply of money, the price (interest rates)
goes down. Let's now move on to the other half of this relationship -- the
demand for money.