International Finance Theory and Policy
by Steven M. Suranovic

Finance 40-1

Interest Rate Determination: Introduction

This section describes how the supply of money and the demand for money combine to affect the equilibrium interest rate in an economy. The model is called the money market model.

A country's money supply is mostly the amount of coin and currency in circulation and the total value of all checking accounts in banks. These two types of assets are the most liquid, i.e., easily used to buy goods and services. The amount of money available to spend in an economy is mostly determined by the country's central bank. They can control the total amount of money in circulation by using several levers, or tools, the most important of which is the sale or purchase of government treasury bonds. Central bank sales or purchases of treasury bonds are called "open market operations."

Money demand refers to the demand by households, businesses and the government, for highly liquid assets such as currency and checking account deposits. Money demand is affected by the desire to buy things in the near future, but is also affected by the opportunity cost of holding money. The opportunity cost is the interest earnings one gives up on other assets in order to hold money.

If interest rates rise, households and businesses will likely allocate more of their asset holdings into interest bearing accounts (usually not classified as money) and will hold less in the form of money. Since interest bearing deposits are the primary source of funds used to lend in the financial sector, changes in total money demand affects the supply of loanable funds and in turn affects the interest rates on loans.

Money supply and money demand will equalize only at one average interest rate. Also, at this interest rate, the supply of loanable funds financial institutions wish to lend, equalizes the amount that borrowers wish to borrow. Thus, the equilibrium interest rate in the economy is that rate which equalizes money supply and money demand.

Using the money market model, several important relationships between key economic variables are shown. These are,

a) When the money supply rises (falls), the equilibrium interest rate falls (rises).
b) When the price level increases (decreases), the equilibrium interest rate rises (falls).
c) When real GDP rises (falls), the equilibrium interest rate rises (falls).


The money market model connects with the foreign exchange market because the interest rate in the economy, determined in the money market, determines the rate of return on domestic assets. In the FOREX market, interest rates are given exogenously, which means they are determined through some process not specified in the model. However, that process of interest rate determination is described in the money market. Economists will sometimes say that once the money market model and FOREX model are combined, interest rates have been "endogenized." In other words, interest rates are now conceived as being determined by more fundamental factors (GDP and money supply), not given as exogenous.

The money market model also connects with the goods market model in that GDP, which is determined in the goods market, influences money demand and hence the interest rate, in the money market model. A thorough discussion of these interrelationships is given in Chapter 60.

International Finance Theory and Policy - Chapter 40-1: Last Updated on 1/11/05