Does an increase in the money supply increase or decrease interest rates?

Question

What I understand is that an increase in the money supply brings about a fall in interest rate as there is more money available, the price of money will be cheaper. But some theory such as liquidity effect posits that increase in money supply will increase in interest rate. Is that they view the problem differently or the two situations are different?

"Money growth also affects interest rates and prices and those in turn will influence stock prices. Assuming that money demand remains constant, increase in money supply raises interest rates thereby increasing the opportunity cost of holding cash as well as stocks. Lured by higher interest earnings, people are likely to convert their cash and stock holdings to interest-bearing deposits and securities with obvious implications for stock prices. Since the rate of inflation is positively related to money growth, an increase in money supply may lower the demand for stocks and assets (as real value of such assets decline due to inflation) resulting in higher discount rates (as banks become more cautious in its lending) and lower stock prices. The rising interest rates and inflation will also adversely affect corporate profits (earnings) leading to lower stock returns (both actual and expected) and thereby making stock possession (as well as new purchase) less attractive."

The above is quoted from an article. It mention that increase in money supply raises interest rates thereby increasing the opportunity cost of holding cash as well as stocks. I don't understand how increasing in money supply would increase interest rate. Could you explain?

Answer 1

I will frame this in the context of modern monetary policy and for the sake of clarity assume we are discussing the American economy.

1) Whenever the Fed wants to bring about some change in the economy, they do so by using one of three tools: open market operations, setting the discount rate, setting reserve requirements. I will only discuss open market operations. The Fed recently introduced two new tools: interest on excess reserves and forward guidance. I include these to be complete.

2) The Fed conducts open market operations through its NY branch's buy/sell desk. In simple terms, the Fed can buy/sell securities in the open market. This causes two things: a change in total bank reserves and security yields (by way of shift demand/supply curves, for example).

Your question is whether or not it makes sense to think about an increase in the money supply causing an increase in interest rates. Since we want to discuss increasing the money supply, let's assume the Fed is buying securities in the open market. Whenever the Fed buys securities, it buys securities from banks and 'pays' the banks by 'adding excess reserves' to the banks' balances at the Fed. Total reserves in the banking system rises. All else being equal, banks have more money to lend. This increases the available supply of loanable funds. Since we assume demand for loanable funds is unchanged, and since interest rates are the equilibrating force in this market, we should see that interest rates drop (because the supply curve shifts right/up).

You might also want to think in therms of what is happening to security yields. If banks start buying a large amount of securities in an effort increase the money supply, we should see a large increase in demand for securities. Assuming all else equal (in particular, assuming that there is no change in the supply of securities) we should see yields on securities fall (this is equivalent to the purchasing prices of securities rising).

And so we see that the logic, whenever we consider either adjustment mechanism, points toward a fall in interest rates whenever the Fed increases the money supply.

With this in mind, I think it is reasonable to conclude that the paper you've cited gets it wrong. And as a point of fact, we have witness recently (during QE) that money growth is not necessarily inflationary...as counterintuitive as that might be.

Answer 2

(1) In IS-LM type models an exogenous increase in the money supply will decrease the interest rate.

(2) IS-LM macro is like 1000 years old. Today central banks set the interest rate and the supply of cash provided by banks is largely endogenous. Most people would still agree that lower interest rates increase the supply of money, all else equal.

(3) These are theoretical predictions. Ultimately it is of course an empirical question that can only be answered with data.

Answer 3

The Fed is responsible for promoting macroeconomic stability, which it accomplishes by controlling the money supply. It is important to realize that by controlling the money supply, the Fed changes interest rates. When the money supply is changed, interest rates follow. However, the Fed’s decision to change the money supply is not the final determining factor of interest rates. The combination of the Fed’s control of money and how consumers react to this change makes up equilibrium in the money market. To find the equilibrium interest rate, you must combine both the demand for money and the supply of money. Once you combine these two factors, you can determine at what interest rate borrowers are willing to borrow and at what point the Fed is controlling the supply of money. At times, the interest rate can change without a change in money supply. If people attempt to increase their money holdings by converting assets into money, interest rates will rise. Conversely, if people decide to increase their assets by converting money into bonds or other non-monetary holdings, the interest rates will decrease. Note that the Fed can only assume how the public will react to a change in the money supply. If consumers for some reason decide to react differently to a policy change, the Fed must then reexamine the situation and try to introduce a policy that will best remedy the problem. Ultimately, it is the consumers and borrowers who change interest rates. The Fed can provide incentives to motivate the public; they cannot ultimately control these variables.

Answer 4

The demand for money slopes downward because as interest rate declines, the opportunity cost of holding money will decline too. Therefore, the quantity of money demanded will increase.

The supply of money in the economy is determined by the Fed through its control over excess reserves in the banking system. The supply of money is vertical which implies that quantity of money supplied is independent of the interest rate.