The cost of money is measured by interest rates. Yet, we notice that interest rates seem to change. Let's explore why this happens.

As they do for any other commodity, supply and demand affect the cost of money. Interest rates are determined by the supply of and demand for money. Inflation, too, is related to the supply and demand forces on money. Sometimes it is not clear which factor drives the rates, but there are clear connections. High inflation = high demand for money = higher interest rates. Low inflation (or deflation) = low demand for money = lower interest rates. Likewise, on the supply side, a large supply of money = low inflation = low interest rates, and a small supply of money = high inflation = high interest rates. The sequence should not suggest cause and effect, but just the relationship.

The causes that produce each effect are more complex, and we would need to study monetary policy to get a better understanding of exactly how it works. Sometimes the cause of inflation is related to the abundance or scarcity of raw materials. This can occur naturally when natural resources are depleted or through human intervention if a manufacturer willfully reduces production of his or her product. Here are some examples:

If demand for goods exceeds their supply, prices rise (inflation), which lowers the money supply, which raises the cost of money. Sometimes the money supply is manipulated by the government to help control inflation. It is not always clear which is the cart and which is the horse.

Interest rates vary because the cost of money changes, as do the supply and demand for money. Interest rates reflect both the cost due to inflation, which varies, and the risk premium associated with a potential borrower.