Money supply and interest rate relationship graphic

The link between Money Supply and Inflation | Economics Help

money supply and interest rate relationship graphic

I think that with money supply control the central bank actively influences The money supply by adding or withdrawing money. By setting the. A graph for the supply and demand for money, as a function of the interest rate, would appear similar to figure on the following page. Figure The Supply. If the long-term interest rate increase(For example, from i* to i** in graph How can the relationship between interest rates and money supply be described?.

The first few dollars out in the economy people are willing to pay a very high interest rate on them.

The link between Money Supply and Inflation

Then every incremental dollar after that people get less marginal benefit. They might not find as good of a place to put that money. Their borrowing it for a reason. Their either going to borrow to consume to buy something that they always wanted that they think will make them happy, or more likely their borrowing it to invest it and hopefully getting a return higher than what they are borrowing at.

You have a marginal benefit curve that would be downward sloping something like that. Maybe it looks something like that. That is our demand curve or our marginal benefit curve. Now, once again this is the exact same logic we use with the demand and supply curve for any good or service. For money might look like this. Those first few dollars someone has a very low opportunity cost of lending it out, so, their willing to lend it out at a very low interest rate.

Then every incremental dollar after that theirs higher opportunity cost, and people will lend it out at a higher and higher rate. Then you have a market equilibrium interest rate.

Let me copy and paste this. Then we could think about what happens in different scenarios. Now we have 2 scenarios that we can work on, and then let me just do 1 more. Let's think of a couple. Let's say that the central bank of our country, in the United States, that would be the Federal Reserve, the central bank prints more money. Then decides to lend out that money.

money supply and interest rate relationship graphic

It is disturbed when central banks print money. The way that it enters into circulation in most countries is that the central bank then goes and essentially lends that money.

The way it's done in the US Fed, most part they go out and buy government securities which is essentially lending money to the Federal Government. They do that because that's considered to be the safest investment. They go out there and they lend money.

money supply and interest rate relationship graphic

If this is our original supply curve. If this is our original supply curve, but now your Federal Central Bank is printing more money and lending it out.

Pt5. How do interest rates affect the money supply?

What is going to happen over here? Your supply curve is going to shift to the right at any given price, at any given interest rate.

Your going to have a larger quantity of money being available. Expectations The speculative demand for money is based on expectations about bond prices. All other things unchanged, if people expect bond prices to fall, they will increase their demand for money. If they expect bond prices to rise, they will reduce their demand for money.

Money supply and demand impacting interest rates

The expectation that bond prices are about to change actually causes bond prices to change. If people expect bond prices to fall, for example, they will sell their bonds, exchanging them for money. That will shift the supply curve for bonds to the right, thus lowering their price. The importance of expectations in moving markets can lead to a self-fulfilling prophecy. Expectations about future price levels also affect the demand for money.

The expectation of a higher price level means that people expect the money they are holding to fall in value. Given that expectation, they are likely to hold less of it in anticipation of a jump in prices. Expectations about future price levels play a particularly important role during periods of hyperinflation.

If prices rise very rapidly and people expect them to continue rising, people are likely to try to reduce the amount of money they hold, knowing that it will fall in value as it sits in their wallets or their bank accounts. Toward the end of the great German hyperinflation of the early s, prices were doubling as often as three times a day.

money supply and interest rate relationship graphic

Under those circumstances, people tried not to hold money even for a few minutes—within the space of eight hours money would lose half its value!

Transfer Costs For a given level of expenditures, reducing the quantity of money demanded requires more frequent transfers between nonmoney and money deposits. As the cost of such transfers rises, some consumers will choose to make fewer of them.

monetary policy - Money supply control vs. interest rate control - Economics Stack Exchange

They will therefore increase the quantity of money they demand. In general, the demand for money will increase as it becomes more expensive to transfer between money and nonmoney accounts. The demand for money will fall if transfer costs decline. In recent years, transfer costs have fallen, leading to a decrease in money demand. Preferences Preferences also play a role in determining the demand for money.

Some people place a high value on having a considerable amount of money on hand. For others, this may not be important. Household attitudes toward risk are another aspect of preferences that affect money demand. As we have seen, bonds pay higher interest rates than money deposits, but holding bonds entails a risk that bond prices might fall.

money supply and interest rate relationship graphic

There is also a chance that the issuer of a bond will default, that is, will not pay the amount specified on the bond to bondholders; indeed, bond issuers may end up paying nothing at all. A money deposit, such as a savings deposit, might earn a lower yield, but it is a safe yield. Heightened concerns about risk in the last half of led many households to increase their demand for money.

Such an increase could result from a higher real GDP, a higher price level, a change in expectations, an increase in transfer costs, or a change in preferences. The reverse of any such events would reduce the quantity of money demanded at every interest rate, shifting the demand curve to the left. The Supply of Money The supply curve of money Curve that shows the relationship between the quantity of money supplied and the market interest rate, all other determinants of supply unchanged.

We have learned that the Fed, through its open-market operations, determines the total quantity of reserves in the banking system. We shall assume that banks increase the money supply in fixed proportion to their reserves. Because the quantity of reserves is determined by Federal Reserve policy, we draw the supply curve of money in Figure In drawing the supply curve of money as a vertical line, we are assuming the money supply does not depend on the interest rate.

Changing the quantity of reserves and hence the money supply is an example of monetary policy. The supply curve of money is a vertical line at that quantity. Equilibrium in the Market for Money The money market The interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money.

Money market equilibrium The interest rate at which the quantity of money demanded is equal to the quantity of money supplied. With a stock of money Mthe equilibrium interest rate is r. Here, equilibrium occurs at interest rate r.

Effects of Changes in the Money Market A shift in money demand or supply will lead to a change in the equilibrium interest rate. Changes in Money Demand Suppose that the money market is initially in equilibrium at r1 with supply curve S and a demand curve D1 as shown in Panel a of Figure Now suppose that there is a decrease in money demand, all other things unchanged. A decrease in money demand could result from a decrease in the cost of transferring between money and nonmoney deposits, from a change in expectations, or from a change in preferences.

In this chapter we are looking only at changes that originate in financial markets to see their impact on aggregate demand and aggregate supply. Changes in the price level and in real GDP also shift the money demand curve, but these changes are the result of changes in aggregate demand or aggregate supply and are considered in more advanced courses in macroeconomics. Panel a shows that the money demand curve shifts to the left to D2.

We can see that the interest rate will fall to r2. To see why the interest rate falls, we recall that if people want to hold less money, then they will want to hold more bonds. Thus, Panel b shows that the demand for bonds increases. The higher price of bonds means lower interest rates; lower interest rates restore equilibrium in the money market.

The fall in the interest rate will cause a rightward shift in the aggregate demand curve from AD1 to AD2, as shown in Panel c. As a result, real GDP and the price level rise. Lower interest rates in turn increase the quantity of investment. They also stimulate net exports, as lower interest rates lead to a lower exchange rate.

An increase in money demand due to a change in expectations, preferences, or transactions costs that make people want to hold more money at each interest rate will have the opposite effect.

The money demand curve will shift to the right and the demand for bonds will shift to the left. The resulting higher interest rate will lead to a lower quantity of investment. Also, higher interest rates will lead to a higher exchange rate and depress net exports. Thus, the aggregate demand curve will shift to the left. All other things unchanged, real GDP and the price level will fall. Changes in the Money Supply Now suppose the market for money is in equilibrium and the Fed changes the money supply.

money supply and interest rate relationship graphic

All other things unchanged, how will this change in the money supply affect the equilibrium interest rate and aggregate demand, real GDP, and the price level?

Suppose the Fed conducts open-market operations in which it buys bonds. This is an example of expansionary monetary policy. The impact of Fed bond purchases is illustrated in Panel a of Figure As we learned, when the Fed buys bonds, the supply of money increases. Panel b of Figure At the original interest rate r1, people do not wish to hold the newly supplied money; they would prefer to hold nonmoney assets. Sometimes the money supply is hard to calculate and is constantly changing.

Large increases in the money supply are often just due to changes in the way people hold money. For example, an increase in credit card use may cause an increase in th broad money supply M4. However, this assumes that V velocity of circulation is constant and Y is constant. However, in practice, it is not as simple as this equation assumes. There are often variations in the velocity of circulation. This explains why quantitative easing increasing the money supply did not cause inflation between and Keynesian view — Liquidity Trap In a recession, there is spare capacity in the economy.

Therefore, an increase in the money supply, merely helps to get unemployed resources used in the general economy. Therefore, in the case of a recession, increased money supply is unlikely to cause inflation. In this situation, there is a fall in the velocity of circulation and this can cause deflation.