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releases/H6/Current Changes in the Money Supply
An increase in the money supply due to expansionary monetary policy by the Federal Reserve implies that the supply curve for money shifts to the right. As is shown
in Figure 4 by the movement of the supply curve from M s to M s , the equilibrium
moves from point 1 down to point 2, where the M s supply curve intersects with
the demand curve Md and the equilibrium interest rate has fallen from i1 to i2. When
the money supply increases (everything else remaining equal), interest
rates will decline.3 CASE Money and Interest Rates
The liquidity preference analysis in Figure 4 seems to lead to the conclusion that
an increase in the money supply will lower interest rates. This conclusion has important policy implications because it has frequently caused politicians to call for a more
rapid growth of the money supply in order to drive down interest rates. 3This same result can be generated using the loanable funds framework. The primary way that a
central bank produces an increase in the money supply is by buying bonds and thereby decreasing the
supply of bonds to the public. The resulting shift to the left of the supply curve for bonds will lead to a
decline in the equilibrium interest rate. W-36 Appendix 4 to Chapter 4 But is this conclusion that money and interest rates should be negatively related
correct? Might there be other important factors left out of the liquidity preference
analysis in Figure 4 that would reverse this conclusion? We will provide answers to
these questions by applying the supply and demand analysis we have learned in this
chapter to obtain a deeper understanding of the relationship between money and
An important criticism of the conclusion that a rise in the money supply lowers
interest rates has been raised by Milton Friedman, a Nobel laureate in economics. He
acknowledges that the liquidity preference analysis is correct and calls the result—
that an increase in the money supply (everything else remaining equal) lowers
interest rates—the liquidity effect. However, he views the liquidity effect as merely
part of the story: An increase in the money supply might not leave “everything else
equal” and will have other effects on the economy that may make interest rates rise.
If these effects are substantial, it is entirely possible that when the money supply
rises, interest rates too may rise.
We have already laid the groundwork to discuss these other effects because we
have shown how changes in income, the price level, and expected inflation affect
the equilibrium interest rate. study guide
To get further practice with the loanable funds and liquidity preference frameworks, show
how the effects discussed here work by drawing the supply and demand diagrams that
explain each effect. This exercise will also improve your understanding of the effect of
money on interest rates. 1. Income effect. Because an increasing money supply is an e...
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This note was uploaded on 01/02/2013 for the course ECON 102 taught by Professor Lisa during the Spring '09 term at RMIT Vietnam.
- Spring '09
- Supply And Demand