The Equilibrium Interest Rate

The demand for money and supply of money can be graphed to determine the equilibrium interest rate. The equilibrium interest rate is the rate of interest at which the quantity of money demanded is equal to the quantity of money supplied. The equilibrium interest rate can be affected by monetary policy adjustments or changes in income levels. The Fed's actions to influence interest rates by adjusting the money supply are known as monetary policy. The Fed uses monetary policy to help stabilize the economy by keeping prices stable. By using monetary policy tools, the Fed can influence the equilibrium interest rate by altering the amount of money in the economy. If the Fed increases the money supply, the supply curve shifts to the right and the equilibrium interest rate falls. Likewise, if the Fed decreases the money supply, the supply curve shifts to the left and the equilibrium interest rate will rise. At very low interest rates, a liquidity trap occurs, which is a situation wherein monetary policy becomes ineffective because increases in the money supply have no effect on interest rates. The demand for money becomes almost perfectly elastic. Several countries' economies have experienced a liquidity trap, including Japan during the 1990s and the United States during the 2007–2009 financial crisis and recession. Essentially, consumers hoard cash because they expect an adverse event to occur (such as worsening economic output or deflation). Because consumers choose to hold large amounts of money, the precautionary and transaction demands for money increase, and the speculative demand for money falls.