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Markets - Money marketsTheory 1 - Equilibrium interest rates - what determines how interesting rates are?Perhaps the easiest way to think of the interest rate is as the price of money. Like any other price it will be determined in a market. In this case the market is the money market. So the interest rate will therefore be determined in the money markets by the interaction of supply and demand. We can see this in the diagram below. The equilibrium interest rate is I*, where the supply of money is equal to the demand for money. 
If the rate of interest were above the equilibrium, then there would be an excess supply of money. People would have a higher level of money balances than they needed. They would use this excess money to invest, by perhaps buying securities or other assets. This would drive the price of securities up (see Theory 4 - interest rates and security prices for more detail on this), and therefore the rate of interest down. This process would go on until the interest rate in the market was once again at equilibrium. If the interest rate were below the equilibrium, the opposite would happen. People would be short of money and so would sell securities to get hold of more liquid money. This would drive down the price of securities (because of an increase in supply of them), and therefore push up the interest rate. |
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