Money Market Interest Rate - How is It Set?

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The money market interest rate is set by the interest rates in the overall economies.

These are basically produced by two things: the Federal Reserve and the demand for money within the economy.

The Federal Reserve acts as the central bank of the United States. Although it's technically independent, its chairman is chosen by the president and confirmed by Congress. Therefore, in effect it is still an institution that responds to political concerns.

Its basic purpose is to maintain the financial system of the United States. That is, to prevent or reduce financial problems such as inflation and recessions. In practice, it also responds to political pressure to keep the economy from unemployment. Because, in practice, these goals conflict, it is constantly attempting to perform a balancing act where the economy functions well, with just a little inflation and just a little unemployment.

One of its main weapons is the federal funds rate. This is the interest rate which banks must pay the Fed when they themselves borrow money. That means it's the cheapest interest rate in the economy.

The higher the federal funds rate, the higher all other interest rates (on bonds, on credit cards, on commercial loans and so forth) will be.

The lower the federal funds rate, the lower banks can afford to set all other interest rates.

The Demand for Money Also Influences Your Money Market Interest Rate

It may seem odd to write about "demand" for money. Of course, everybody wants as much money as possible as possible.

However, demand for money means how much people and businesses want to borrow money.

In economic good times, people want to spend and buy. They take out loans to buy houses, cars and consumer goods. They take out student loans to go to school. They max out their credit cards.

Businesses do the same. Major corporations introduce new product lines, buy up other businesses and expand total operations - so they issue new bonds. Small manufacturing companies open new factories, so they borrow money. Your local pizza parlor opens a second branch on the other side of town, so they get a loan from a local bank.

Therefore, the demand for (borrowed) money is high, which drives up its "costs" - interest rates.

The Money Market Interest Rate Falls When Demand for Money Falls

The opposite happens when economic times are not so good, as we've seen 2007-2010.

People don't buy houses on speculation and keep using their old cars instead of buying new ones. They pay down their credit card debt. Credit card companies reduce credit lines so people can't borrow as much.

Banks make borrowing money next to impossible for both consumers and businesses.

Therefore, the demand for (borrowed) money falls, which tends to drive interest rates lower.

The Federal Reserve attempts to set a federal funds rate that will stimulate demand for money during economic bad times (by making interest rates lower), to increase economic activity to create jobs to reduce unemployment and which will reduce demand for money during economic good times (by making interest rates lower), to decrease econonimic activity to reduce inflation.

Of course, people with funds in money funds simply want to get the highest money market interest rate they can. We don't control the national economy. But we are affected by it.

Next: Money Market Account Interest Rates

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