MONEY DEMAND AND ITS EFFECT ON INTEREST RATES
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The Federal Reserve's monetary policy and the aggregate savings rate in the economy determine the supply of money. Businesses, the government, and consumers all demand money. Their demand combines with the supply of money to determine the rate of interest.
Businesses need capital to run their operations and to make new investments. Their level of borrowing depends greatly on the investment opportunities that exist. Corporations may choose to borrow from a bank or decide to issue their own bonds. Either way, their aggregate demand for capital greatly influences interest rates.
The U.S. Government has traditionally been a big borrower. Any time that the government has a budget deficit, it must borrow money to make up the difference. After years of running budget deficits, the U.S. Government has accumulated a huge debt. In order to meet its debt obligations, it must borrow more funds. The government borrows by issuing government securities such as Treasury bills, Treasury notes, and Treasury bonds.
Consumers like you may not borrow in huge quantities, but when you combine all consumers in our economy, we do an awful lot of borrowing. Mortgages, car loans, and student loans are just a few of the ways that we borrow. On an aggregate basis, consumer demand for borrowed money does impact the determination of interest rates.
Like any commodity, there is supply and demand of money, which determines its price or interest rate. Interest rates, in turn, affect the value of many kinds of investments and can be a major factor in an investor's decision to buy or sell.
On the next page, we will review what we have learned.