The Federal Reserve strives to maintain stability in financial markets, and the concept of equilibrium is closely related to this goal of stability. Equilibrium in the money market occurs at an interest rate where money supply equals money demand.

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While we are accustomed to thinking about supply and demand for consumer goods and services, there is also a supply and demand for money. The supply of money in the economy is controlled by the Federal Reserve Open Market Committee. The demand for money comes from consumers and businesses needing money to make routine purchases, to pay for unanticipated expenses, and to invest if opportunities arise. The equilibrium interest rate is found at the point where the supply and the demand for money intersect.

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The supply of money is a determinant of interest rates, and interest rates influence the rate of capital investment, productivity growth rates, and ultimately economic growth and our material standard of living. Most of the productivity gains that our economy has made in the last few years are related to advancements in technology. If borrowing costs are too high, businesses will continue to use old equipment, which will tend to slow the rate of productivity growth.

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If the money supply is growing too slowly, interest rates will rise. Higher interest rates reduce debt-financed spending, and thus slow the rate of economic growth. As economic growth slows, unemployment will tend to rise. In contrast if the money supply grows too rapidly, demand-pull inflation may occur as too much money chases too few goods, and tight labor markets put upward pressure on wages.

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The supply of money in the economy impacts output and income. For example, an increase in the money supply will reduce interest rates and spur new investment, thus raising productivity and income. Excessive growth in the money supply will lead to inflation.

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The money supply affects real GDP by way of aggregate demand. For example if the Federal Reserve feels that the economy is growing too slowly, it can expand the money supply. A rising money supply lowers interest rates, increases aggregate expenditures, and thus ultimately increases aggregate demand.

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The Federal Reserve conducts monetary policy by manipulating the money supply. Expansionary monetary policy increases the money supply to expand economic output, while contractionary monetary policy reduces the growth rate in the money supply to reduce spending and control inflation.

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