Discuss the determinants of the equilibrium interest rate. What can the Fed do to change the interest rate?
What will be an ideal response?
The interest rate is determined through the interaction of the demand and supply of money. The demand for money consists of the transactions, precautionary and speculative demands for money. The demand for money curve is downward sloping reflecting the inverse (negative) relationship between the quantity of money demanded by people and the interest rate. The supply of money curve is expressed as a vertical line because it is independent of the rate of interest. The supply of money can be changed by the Fed changing required reserves, the discount rate and by using open market operations. The Fed should increase the money supply to reduce interest rates.
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