At the core of monetary economics lies a fundamental principle: money supply and interest rates typically move in opposite directions.

When a central bank increases the money supply—injecting more liquid assets into the economy, there tends to be more money available for lending.

This abundance lowers the cost of borrowing, pushing interest rates down. Conversely, when the money supply tightens, less capital circulates, making borrowing more expensive and driving interest rates up. This inverse relationship is a key mechanism through which central banks influence economic activity and inflation

Central Banks Role in Controlling Money Supply

Central banks, such as the Federal Reserve or Bank Indonesia, actively manage the money supply using several monetary policy tools. Open market operations, which involve buying or selling government securities, directly affect the amount of money circulating. For example, when the central bank buys securities, it credits banks reserves, increasing liquidity and typically lowering interest rates. On the other hand, selling securities absorbs liquidity, reducing the money supply and raising rates.

Other tools include adjusting the discount rate—the interest rate charged to commercial banks for short-term loans and changing reserve requirements, which dictate the fraction of deposits banks must hold without lending. Lowering these rates or requirements encourages lending and expands the money supply, while raising them contracts it.

Impact on Short-Term vs. Long-Term Interest Rates

While money supply changes primarily influence short-term interest rates, long-term rates are also affected but to a lesser degree. Short-term rates, such as the federal funds rate or benchmark lending rates, respond quickly to shifts in liquidity. For instance, Bank Indonesia's recent decision to lower its benchmark interest rate to 5.5% in May 2025 reflects an accommodative monetary stance aimed at supporting growth amid stable inflation.

Long-term interest rates, however, incorporate additional factors like inflation expectations, economic growth forecasts, and risk premiums. Even if the money supply expands, if investors anticipate higher inflation or economic uncertainty, long-term rates may remain elevated despite ample liquidity.

Liquidity Preference and Risk Premium: Beyond Money Supply

Interest rates are not solely dictated by money supply, investor behavior and risk perceptions also play crucial roles. The liquidity preference theory suggests investors demand higher yields for longer-term or less liquid investments, reflecting a trade-off between liquidity and return. Meanwhile, the risk premium compensates lenders for the possibility of default or economic instability.

Therefore, even with an increased money supply, if market participants perceive greater risk, interest rates may not fall proportionally. This dynamic interplay explains why monetary policy must be carefully calibrated to balance liquidity provision with economic realities.

Expert Insight: The Nuanced Relationship

Harvard economist Jeffrey Frankel states that central banks should respond to inflation increases with more-than-proportional interest rate increases, known as the Taylor principle.

Federal Reserve Chair Jerome Powell has noted that, "We're closer to the neutral rate, which is another reason to be cautious about further moves" regarding interest rate policy in 2025.

The money supply exerts a significant influence on interest rates through its effect on liquidity and borrowing costs. Central banks manipulate this supply to steer economic growth, control inflation, and stabilize financial markets. However, interest rates are also shaped by investor preferences and risk assessments, making the relationship complex and multifaceted.

For policymakers and investors alike, appreciating how money supply interacts with interest rates is essential for navigating the financial landscape of 2025 and beyond. This knowledge informs decisions ranging from borrowing and lending to portfolio management and economic forecasting.