What Determines Interest?

We have concluded that investment is influenced by the rate of interest. That moves us forward, but raises another question: What determines the rate of interest? As we learned in an earlier chapter, the interest rate is linked to the supply of money by the "liquidity preference" relationship. Let's go back and take another look at that relationship.

Here the "liquidity preference" diagram.

Figure 2: Liquidity Preference

In the diagram, we show the quantity of money on the horizontal axis and the interest rate on the vertical axis. For example, if the rate of interest is R_a, people want to hold M_a of money, whereas if the rate of interest were to go down to R_b, people would increase their demand for monetary assets to M_b.

The idea (remember) is that holding money is a trade-off between convenience and interest income. People keep money in their wallets or in low-interest checking accounts to have the convenience of being able to make payments without making special arrangements at the bank -- that is, money saves "shoe leather costs." But the cost of this convenience is that they give up the interest income. If the cost goes up -- the interest goes up -- then people cut back on the assets they hold in cash and in their checking accounts, shifting their assets into higher-yielding, nonmonetary assets such as bonds.