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When the interest rate increases, I learned that money supply decreases because people put their currency back in banks in forms of assets and tend to save more, spend less.

However, money supply includes deposits as well as currency. So what I'm really curious about is whether a rise in interest rate actually decreases money supply.

Doesn't a rise in interest rate just decrease the ratio of currency in the economy and increase the ratio of deposits in the bank, the sum (deposits + currency) remaining the same? So shouldn't money supply technically stay the same?

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    $\begingroup$ This is your third question today, and your second one that boils down to "what is the money supply". Please stop spamming and search the site or the internet for a bit. You are bound to find your own answer as this is a basic definition. $\endgroup$
    – Giskard
    Commented Dec 16, 2017 at 10:13
  • $\begingroup$ All that comes out on the internet is that money supply = currency + deposit. Internet only explains that the rise in interest rate decreases the money supply. It does NOT explain HOW this works in the context of the definition of money supply. I don't think money supply decreases technically because a rise in interest rates just means a decrease in currency and increase in deposit. So the sum of these two should stay the same. I want sb to explain why this thought is wrong I'm asking this question here after trying to find an answer by myself for many hours. $\endgroup$
    – Robin311
    Commented Dec 16, 2017 at 10:17

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Maybe this helps: The interest rate is the price of money. If the supply of something goes down, while the demand stays the same, the price moves up. So if the supply of money were to go down, the interest rate would go up, if the demand for money stays the same.

Now, to reduce the money supply and with that to keep an economy from overheating, the central bank could just collect dollar bills and keep them in a vault for later use. Less money, means higher interest rates, means less investment, means less heat in the economy. However, it is easier for the central bank to simply change the price it charges banks borrowing from it overnight. This is just one of three policy tools that the bank uses, the other two being open market operations and reserve requirements. By increasing the price of money, the effect is similar to a change in the money supply, so that the central bank effectively reduces the money supply.

Hope this helps. Have fun studying this! I really enjoy the topic, even though I still know way too little about it!

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If the interest rate increase people put their money in SAVINGS account, not in DEPOSIT accounts. People also buy BONDS. This is what keynes said, and what is behind the LM curve in the ISLM model.

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