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Money supply and demand impacting interest rates

Examples showing how various factors can affect interest rates. Created by Sal Khan.

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  • leaf red style avatar for user Ulisses Morais
    Around "" why demand goes up/right if consumers are borrowing less money?
    (31 votes)
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  • blobby green style avatar for user CoutureGlam
    This helped alot..until I got to where you shift demand rather than the supply..how do you know whether to move the demand or supply curve?
    (8 votes)
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    • blobby green style avatar for user Johnny Johnson
      I think we're close to answering the question about government deficits on interest rates. I agree with Trevor, however, I don't like how he says that government deficits always crowd out public investment. This is only the case in a booming economy, but not what happens during a recession.

      A better way to think about this is if a government runs a deficit, then they have to issue more bonds in the market place in exchange for cash. More bonds in circulation will drive prices down and yields up, thus interest rates will increase.
      (3 votes)
  • orange juice squid orange style avatar for user Gabe Webb
    So if the Federal Reserve buys U.S Government bonds at an interest rate, does that mean the Federal Government has to pay the Federal Reserve back the notes, plus interest when they mature?

    And if that is the case, how could the Federal Government ever, not be indebted to the Federal Reserve, if the second money is created and circulated, there is debt attached to every dollar?

    This seem mathematically absurd for any country to distribute their money supply in this way and it would be destined to collapse on itself due to the fact that the Government and its people will forever be paying off the debt interest on money that was created out of thin air. So how do we come up with the interest to pay on the money on the Government bonds, bought by the Federal Reserve?

    It would seem to me that The Federal Reserve would have to print out more money just so the Government could pay off the interest on the last so called "Loan".

    Doesn't this sound ridiculous to anyone else? Is there not a better way of doing this? Or am I missing something here?
    (6 votes)
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    • male robot hal style avatar for user Andrew M
      The government pays interest and is indebted to anyone who holds its bonds. It makes no difference if the central bank is holding some of them. If the central bank didn't buy those bonds, someone else would have to hold them. The government's need to borrow has nothing to do with the central bank. It has to do with the government taking in less than what it spends.
      (6 votes)
  • blobby green style avatar for user Hai Nguyen
    Hmm I dont get it. In the last video Sal mentioned that the supply curve for money will be a vertical line, which represents that it isnt effected by the interest rate. Why in this video it suddenly turned into a diagonal line like normal supply curves?
    (4 votes)
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  • spunky sam blue style avatar for user Greg
    Around he says that the government puts more money into the system, usually by the central bank purchasing government bonds since they are safe. How does this affect the general economy if the money is just reinvested in the government? Is it because the government will use this money to purchase more goods and services on the open market?
    (4 votes)
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    • leaf green style avatar for user Jeffrey Pierce
      Remember that the central bank is itself typically a government agency, such as the Federal Reserve System. When it purchases government bonds, the bondholders -- either private individuals or privately owned financial institutions -- receive money from the central bank. Thus, the civilian economy receives money from the public sector, which can be used for other aspects of GDP, such as business investment or household consumption, which in turn generates economic growth.
      (3 votes)
  • blobby green style avatar for user esselbismark82
    what is the effect on interest rate when supply is fixed?
    (2 votes)
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    • purple pi purple style avatar for user hugoncosta
      What do you mean? Check this graph: https://i.imgur.com/0vFoYVn.png I have used my extensive paint skillz to graph the relation between Interest Rate and Real Money supply. You can see that there is an inverse relationship - when the Central Bank increases Money Supply (Ms), the MS/P line (Real Money Supply) shifts to the right along the L function (liquidity as a function of volume and interest rate), thereby decreasing the interest rate.
      (4 votes)
  • orange juice squid orange style avatar for user Michael Lopez
    at , Sal mentions that consumer savings is going down (decreasing) and that the money supply curve will shift to the left. I'm confused about this. Wouldn't a decrease in savings increase the supply of money ?
    (3 votes)
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    • piceratops ultimate style avatar for user Bart
      Savings are one of the sources of money in the Fractional Reserve System, as Sal explains in the previous videos. Reduced savings would basically mean banks can lend less and therefore money supply would decrease. What's confusing here to me is that Sal doesn't explain that demand movement, and therefore resulting positive (offsetting) or further negative impact on supply, is dependent on the market situation. For example, although I'm not an expert, in a market where actors would feel safe enough to reduce saving by investing satisfying large portion of the investment needs, the demand might just as well go down rather than grow.
      (1 vote)
  • blobby green style avatar for user nanda kumar
    Until the third scenario,I thought whenever we spoke of demand we spoke of all players apart from the government influencing demand and when it came to supply,I thought it was only the government controlling supply...but in the third scenario, when government borrows more, how does demand go up?...it led me to another doubt...is the government not on the same side of things as the federal reserve...meaning do the 2 have to be viewed as separate entities and not one...?
    (2 votes)
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    • leaf green style avatar for user Benjamin Gradl
      The federal reserve acts independently of the government. The central bank in the state lends money to the government. . The government borrows money from the reserve just like a person who was buying a house would take out loans from a bank, though the federal reserve only deals with major banks and the government. Interest rates are not made by the government, but by the Federal Reserve.
      (2 votes)
  • leaf blue style avatar for user Mazen Elsabrouty
    For the second part where consumer savings (CS) decrease, how does demand increase? The way I think about this situation is that if CS decreases then consumption increases and thus at a higher interest rate (due to the decrease in supply) we are less willing to borrow money to finance our increased consumption expenditure and so demand decreases.
    (2 votes)
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    • aqualine ultimate style avatar for user Stefan van der Waal
      With your logic the demand curve won't change. All that will happen is that a different point on the line will get picked.

      With the logic of Sal, when people start saving less it means they are consuming more. During that spending spree they are prepared to lend more at the same interest. Because of that the curve will move to the right.
      (2 votes)
  • male robot hal style avatar for user Reddy, Jaiden
    I kind of don't understand these graphs. Why is the interest rate only where the lines meet? Couldn't you say that at low quantity there is a high demand therefore people will buy it there?
    (2 votes)
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    • ohnoes default style avatar for user Tejas
      The interest rate is where the lines meet because that is an equilibrium. If you have a lower interest rate, then there will be more people who need loans than there are people who want to loan money out. Therefore, some of those people who need loans will offer to pay a slightly higher interest rate in order to get priority. That pushes the interest rate up to the point where there are an equal number of lenders as borrowers.
      (2 votes)

Video transcript

Now that we know that we can view interest rates as essentially the price of renting money. I want to go through a bunch of scenarios just so we can understand how different things that happen in the economy might effect interest rates. I just draw a bunch of supply and demand curves right over here. Once again we're talking about the market for essentially renting money. That right over here is the price of money, which we know is the interest rate on the vertical axis. Then the horizontal axis we have the quantity of money that is borrow or lent in a given time period. Quantity and this is a given time period that is borrowed or lent. Quantity borrowed in a year. We know there is some ... if we just wanted to draw a demand curve our starting demand curve. The first few dollars out in the economy people are willing to pay a very high interest rate on them. Then every incremental dollar after that people get less marginal benefit. They might not find as good of a place to put that money. Their borrowing it for a reason. Their either going to borrow to consume to buy something that they always wanted that they think will make them happy, or more likely their borrowing it to invest it and hopefully getting a return higher than what they are borrowing at. You have a marginal benefit curve that would be downward sloping something like that. Maybe it looks something like that. That is our demand curve or our marginal benefit curve. The supply curve. Now, once again this is the exact same logic we use with the demand and supply curve for any good or service. For money might look like this. Those first few dollars someone has a very low opportunity cost of lending it out, so, their willing to lend it out at a very low interest rate. Then every incremental dollar after that theirs higher opportunity cost, and people will lend it out at a higher and higher rate. Then you have a market equilibrium interest rate. Let me copy and paste this. Then we could think about what happens in different scenarios. Copy and paste. Now we have 2 scenarios that we can work on, and then let me just do 1 more. 3 scenarios. Let's think of a couple. Let's say that the central bank of our country, in the United States, that would be the Federal Reserve, the central bank prints more money. Then decides to lend out that money. That actually is ... in the previous video I talked about the central bank printing money and then dropping it from helicopters, that is not how money is actually distributed. It is disturbed when central banks print money. The way that it enters into circulation in most countries is that the central bank then goes and essentially lends that money. The way it's done in the US Fed, most part they go out and buy government securities which is essentially lending money to the Federal Government. They do that because that's considered to be the safest investment. They go out there and they lend money. If this is our original supply curve. If this is our original supply curve, but now your Federal ... Central Bank is printing more money and lending it out. What is going to happen over here? Your supply curve is going to shift to the right at any given price, at any given interest rate. Your going to have a larger quantity of money being available. It might look something like ... your new supply curve might look something like that. Assuming that's the only change that happens you see its effect. Your new equilibrium price of money, the rent on money, or the interest rate on money is now lower. That's why when the Federal Reserves say I want to lower interest rates, they do so by printing money. They print that money, and they lend it out in the market. That essentially has the effect of lowering interest rates. Let's think about another situation. Let's say this is the Fed prints and lends money. Their lending the money by buying government bonds. When you buy a government bond, your essentially lending that money to the Federal Government . I've done other videos on that where we go into a little bit more detail on that. Let's think of another situation. Let's think about consumer savings go down. One interesting thing about savings, savings and investment are two opposite sides of the same coin. When you save money ... you literally put it into a bank. You have the whole financial system right over here. This is the finincial system. Financial system. That money goes out and is lent to other people. For the most part, hopefully, that money when it's lent is used to invest in someway. This is lending. If consumer savings goes down that means the supply of money will be shifted to the left. At any given price and any given interest rate their be less money available. In this situation our supply curve is shifting to the left. That would increase interest rates. Then you could even make an argument that if consumers savings is going down consumers are going to borrow less as well. You could argue that maybe demand would go up as well. Your demand could go up and that would make the equilibrium interest rate even even higher. Let's do another scenario. Let's say that the Federal Government in an effort to ... let's say that for whatever reason, their trying to finance a war or some type of public works project and they don't want to raise taxes. The government decides to borrow a lot more money. The government is essentially going expand it's deficit. The government is going to borrow money. Here our supply isn't changing. I'm assuming the Central Bank isn't changing it's policies, how much it's printing. Savings rates aren't changing. The demand is going to go up. Government is borrowing money. The government is going to borrow more money than it was already doing. At any given price the demand for money is going to increase. We're going to shift to the right, and our new equilibrium interest rate, remember the rental price of money, is going to go up. The whole point of this is just to show you that you really can't think about money like any other good or service. If the supply of money goes up then the price of money, which is interest rates, will go down. Let me write this down. If the supply goes up then the price, which is just the interest rates goes down. If the demand goes up, then the price of money will go up. Interest rates will go up. Then we think about all the other combinations where demand goes down, then interest would go down. Which is essentially just price. If supply went down, interest rates would go up. If something becomes more scarce the price of it goes up. The whole point of this is just to show that it's not that complicated. You'll see people say, oh, government borrowing, it's crowding out other savings, interest rates go up, and it sounds like something deep is happening. They are just talking about the supply and demand for money. You just have to remember that interest rates really are nothing more than the rental price for money.