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I am aware of how the interest rates affect the demand for a currency, but am baffled by how it affects the supply for a currency. I've read conflicting theories. Is it true that an increase in the interest rate increases the supply of a currency?

Many thanks

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Not all interest rates are equal. The interest rate by which banks lend each other reserves for short periods of time does in no way have to correlate to other interest rates. Banks are special!

To understand banking, you have to understand maturity mismatching. Banks create liquidity/money by borrowing short term and lending long term. So if there is one billion dollars in the banking system, this allows say the banks to create 10 billion in bank deposits and loans.

To finance this, banks require base money. This they acquire from each other, deposits and from special banks called primary dealers. When the rate at which banks lend each deviates from the target Fed Funds rate, the Fed buys or sells repos to primary dealers in the hope they will buy or sell with the rest of the banking system and the target Fed Funds rate will be achieved. So say the Fed has a target Fed Funds rate of 100%. This means they will not create more money (the base money supply) while banks are lending each other loans that are under this rate. On the flip side, if the target Fed Funds rate is 0%, the Fed will be constantly creating MB and using it to buy bank assets.

Base money can be thought of as a loan with an infinitely small maturation. In reality banks operate by dealing with longer term loans that still are mismatched with even longer term assets. So if a bank creates a 3 month debt, balanced by a five year credit they are creating liquidity or money as well. The extent to which this happens is difficult to quantify but is best conceptualized by time difference between loans and assets in the aggregate. Higher interest rates, will hinder a banks ability to create liquidity (or higher monetary aggregates) which will relatively reduce the money supply.

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Maybe it will be useful for you to start:
[http://www.wisegeek.com/what-is-the-relationship-between-money-supply-and-interest-rate.htm][1]"
As asked I summarize the core ideas, written in the link.
So, higher interest rate decreases the supply of the money:

  1. The central bank can set the reserve percentage, which tells how much percentage of the total money of each commercial bank must be hold back. The higher this rate, the less money the banks can give to the consumers as loans.
  2. Central bank also can set the target percentage, which is the interest rate between commercial banks or between commercial banks and the central bank. The higher this rate, the more the banks must pay when making loans among them, so the less money remains to loan to the consumers.
  3. Central bank can set the consumer interest rate, too. The higher rate the consumers have to pay after their loans, the less money remains at themselves. So the supply of the money decreased. (And as I think, but not in the link: if the interest rate after deposits are high, more people will think that it is better for them to save their money in the bank and not spend it for something else. If it is combined with point 1., it will also decrease the supply of money.)
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  • $\begingroup$ It is better to incorporate the gist of the linked information in the body of the answer. If you insist on posting just the link consider doing it in a comment. $\endgroup$ – Giskard Feb 5 '16 at 13:02

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