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 (Figure 1). Within an economy, there are numerous factors that contribute to the level of the interest rate:
- 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.
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.