The Equilibrium Interest Rate

In a economy, equilibrium is reached when the supply of money is equal to the demand for money.

Learning Objective

Use the concept of market equilibrium to explain changes in the interest rate and money supply

Key Points

The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor).
Factors that contribute to the interest rate include: political gains, consumption, inflation expectations, investments and risks, liquidity, and taxes.
In the case of money supply, the market equilibrium exists where the interest rate and the money supply are balanced.
The real interest rate measures the purchasing power of interest receipts. It is calculated by adjusting the nominal rate charge to take inflation into account.

Terms

equilibrium
The condition of a system in which competing influences are balanced, resulting in no net change.
interest rate
The percentage of an amount of money charged for its use per some period of time (often a year).

Full Text

Interest Rate

The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor). Equilibrium is reached when the supply of money is equal to the demand for money. Interest rates can be affected by monetary and fiscal policy, but also by changes in the broader economy and the money supply.

Factors that Influence the Interest Rate

Interest rates fluctuate over time in the short-run and long-run . Within an economy, there are numerous factors that contribute to the level of the interest rate:

Fluctuation in Interest Rates

This graph shows the fluctuation in interest rates in Germany from 1967 to 2003. Interest rates fluctuate over time as the result of numerous factors. In Germany, the interest rates dropped from 14% in 1967 to almost 2% in 2003. This graph illustrates the fluctuations that can occur in the short-run and long-run. Interest rates fluctuate based on certain economic factors.

Political gain: both monetary and fiscal policies can affect the money supply and demand for money.
Consumption: the level of consumption (and changes in that level) affect the demand for money.
Inflation expectations: inflation expectations affect a the willingness of lenders and borrowers to transact at a given interest rate. Changes in expectations will therefore affect the equilibrium interest rate.
Taxes: changes in the tax code affect the willingness of actors to invest or consume, which can therefore change the demand for money.

Market Equilibrium

In economics, equilibrium is a state where economic forces such as supply and demand are balanced and without external influences, the equilibrium will stay the same. Market equilibrium refers to a condition where a market price is established through competition where the amount of goods and services sought by buyers is equal to the amount of goods and services produced by the sellers. In the case of money supply, the market equilibrium exists where the interest rate and the money supply are balanced. The money supply is the total amount of monetary assets available in an economy at a specific time. Without external influences, the interest rate and the money supply will stay in balance.

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