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I was under the impression that in the long run, a larger money supply resulted in lower interest rates. According to the Quantity Theory of Money, see below figure, an increase in the money supply -> An increase in price levels.

enter image description here

Increasing price levels == increasing inflation rate.


Fisher Effect:

According to the Fisher Effect:

Nominal Interest Rates = Real Interest Rates + Inflation

Changes in the money supply should not affect the Real Interest Rate in the long term therefore there is a 1 for 1 increase in Nominal Interest Rates and Inflation in order to maintain the equation.

The Chart suggests that an Increase in money supply => Higher prices == Inflation, which i believed meant lower interest rates.

But the Fisher Effect seems to be suggesting the opposite, hence my confusion.

I would appreciate any help in clarifying this, thanks in advance.

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  • $\begingroup$ Since the nominal interest rate is determined as the sum of the real interest rate plus inflation, how did you arrive at the impression that inflation decreases the nominal interest rate? $\endgroup$ – Alecos Papadopoulos Mar 28 '17 at 19:01
  • $\begingroup$ @AlecosPapadopoulos Thanks for replying. Based on the figure in the original question, the increase in money supply shifts the equilibrium point from A to B, which according to the Axis on the right, increases prices. In order to increase the money supply, i thought the interest rates had to decrease. $\endgroup$ – Hans Rudel Mar 28 '17 at 19:56
  • $\begingroup$ The interest rates "had to" decrease? Why? $\endgroup$ – Alecos Papadopoulos Mar 28 '17 at 20:22
  • $\begingroup$ khanacademy.org/economics-finance-domain/macroeconomics/… Timestamp 3:15 $\endgroup$ – Hans Rudel Mar 28 '17 at 21:16
  • $\begingroup$ I may have misunderstood something though, i just bought a txtbook and have been reading through it as i never studied economics at School/uni and regret not having a better understanding of it. $\endgroup$ – Hans Rudel Mar 28 '17 at 21:17
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ceteris paribus - other things staying the same

What happens with a changing money supply depends on what other things stay the same in your thought experiment. Possibilities might include:

  1. If real interest rates stay the same but you manage to increase the money supply and inflation, then nominal interest rates must rise by definition. Historically, nominal interest rates have been higher in inflationary periods than in periods of price stability or deflation

  2. If nominal interest rates stay the same but you manage to increase the money supply and inflation, then real interest rates must fall by definition. This is likely to lead to an inflationary spiral as people borrow cheaply in real terms, increasing demand and the money supply further and so pushing prices higher

  3. If you force inflation to stay the same but you manage to increase the money supply excessively compared with that inflation, you may need other controls such as price regulation. This could lead to shortages of goods or an asset price bubble, at which point things other than money become important while interest rates could become less relevant

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  • $\begingroup$ Hi Henry, thanks for replying. So im basically comparing apples and oranges then. One question though, I thought the FED increased the money supply by buying Government bonds (I believe reducing the "Discount Window" also increases the money supply. Reducing the Reserve Ratio also does a similar thing via the money multiplier.So when the FED buys bonds, that increases demand for bonds which results in higher prices => lower interest rates (unless i'm mistaken?). If thats correct, what tools do they have at their disposal to maintain the Nominal Interest Rate at its pre-bond buying level? $\endgroup$ – Hans Rudel Mar 29 '17 at 19:27
  • $\begingroup$ During Quantitative Easing the Federal Reserve Banks wanted to keep interest rates low. But to try put a floor under nominal interest rates, the Fed voluntarily paid interest on excess reserves (IOER): $0.25\%$ from 2009 to 2015, and $1\%$ now that interest rates are rising, so commercial banks would not be keen to lend at lower rates $\endgroup$ – Henry Mar 29 '17 at 20:52
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Both the picture posted by the OP, as well as an online tutorial the OP linked to, examine shifts in the supply of money, leaving the money demand unaffected.

(I also note that the picture looks at money demand more as "liquidity demand", while the on-line tutorial examines "demand for borrowing funds")

The Fisher Hypothesis first of all relates to expected inflation, and compacts movements in both the supply curve as well as in the demand curve, as a result of inflationary expectations.

One can see also this answer.

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