What is the Relationship Between Money Supply and Interest Rates?

The money supply refers to all of the money held by the public, including transaction account balances, cash or traveler's checks. A transaction account is a bank account that allows direct payment to a third party. For example, you can use a check or debit card to purchase produce at your local farmer's market. Cash refers to the amount of currency and coin in circulation outside of bank accounts. Traveler's checks are issued by non-bank firms, such as American Express. Basically, the money supply is the amount of money that a nation has available at any given time.

Interest refers to the amount of money that a person pays to take out a loan. Financial institutions profit when they loan out a certain amount of money and require the borrower to repay the initial loan, plus an additional amount of money, which is a specific percentage of the loan.

Interest rates have a direct impact on the amount of money in circulation. In the United States, the Federal Reserve, or Fed, raises and lowers the discount rate, which is the interest rate that it charges banks for borrowing money, to either constrict or expand the money supply. When the Fed lowers the discount rate, banks lower interest rates in order to make more loans, which increases the amount of money in circulation. When the Fed wants to reduce the amount of money in circulation, it raises the discount rate, which results in higher interest rates and fewer loans.