The link between Money Supply and Inflation | Economics Help
Read about the link between the supply of money and market interest rates, and find out why money supply alone can't explain interest rates. I think that with money supply control the central bank actively influences The money supply by adding or withdrawing money. By setting the. 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?.
Hard to Measure Money Supply. 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. In this situation, increasing the money supply will not necessarily cause inflation.
Summary of Link Between Money Supply and Inflation In normal economic circumstances, if the money supply grows faster than real output it will cause inflation. In a depressed economy liquidity trap this correlation breaks down because of a fall in the velocity of circulation.
Money supply and demand impacting interest rates (video) | Khan Academy
This is why in a depressed economy Central Banks can increase the money supply without causing inflation. This occurred in the US between However, when the economy recovers and velocity of circulation rises, increased money supply is likely to cause inflation. 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. 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. It might look something like Assuming that's the only change that happens you see its effect. Your new equilibrium price of money, the rent on money, or the interest rate on money is now lower.
That's why when the Federal Reserves say I want to lower interest rates, they do so by printing money.
They print that money, and they lend it out in the market. That essentially has the effect of lowering interest rates. Let's think about another situation.
Money supply and demand impacting interest rates
Let's say this is the Fed prints and lends money. Their lending the money by buying government bonds. When you buy a government bond, your essentially lending that money to the Federal Government. I've done other videos on that where we go into a little bit more detail on that. Let's think of another situation.
Let's think about consumer savings go down.
One interesting thing about savings, savings and investment are two opposite sides of the same coin. When you save money You have the whole financial system right over here. This is the finincial system. That money goes out and is lent to other people. For the most part, hopefully, that money when it's lent is used to invest in someway. If consumer savings goes down that means the supply of money will be shifted to the left.
At any given price and any given interest rate their be less money available. In this situation our supply curve is shifting to the left. That would increase interest rates.
Then you could even make an argument that if consumers savings is going down consumers are going to borrow less as well. You could argue that maybe demand would go up as well. Your demand could go up and that would make the equilibrium interest rate even even higher.
Let's do another scenario. Let's say that the Federal Government in an effort to The government decides to borrow a lot more money. The government is essentially going expand it's deficit. The government is going to borrow money. Here our supply isn't changing.
I'm assuming the Central Bank isn't changing it's policies, how much it's printing. Savings rates aren't changing. The demand is going to go up. Government is borrowing money. The government is going to borrow more money than it was already doing. At any given price the demand for money is going to increase. We're going to shift to the right, and our new equilibrium interest rate, remember the rental price of money, is going to go up.
The whole point of this is just to show you that you really can't think about money like any other good or service.