# Why does increasing the money supply decrease the interest rate in layman's terms?

If money supply increases, then I will have more money in my pocket to spend more. I imagine that prices will also increase over time to adjust to there being more money in circulation. Is it because that now, fewer people want to save because they have so much money to spend that the interest rate in general decreases when the money supply increases? Can someone explain it to me from an average Joe perspective, as in how does the increase of the money supply affects me personally and why the interest rate would decrease?

On most fundamental level it is because interest rate is price for money. In the same way as price of milk goes down when supply of milk increases (ceteris paribus) price of money goes down when supply of money increases. For example, consider the following diagram from Blanchard et al. Macroeconomics below. You have supply of money (by central bank) and then you have demand for money by people. Interest rate ensures that demand for money = supply of money. If supply increases (shift to the right) interest rate has to decrease otherwise people would not be willing to get and hold that additional money.

• @UtilityMaximiser I do not think it is an abuse of terminology. Mankiw in his macroeconomics also calls interest rate price - on p65 he literary says: "the interest rate is the price that has the crucial role of equilibrating supply and demand" - that is direct quote from a leading textbook from one of the most cited macroeconomists of our time so I do not think the comparison is wrong. Also, there is more interest over long time than in short time because money in present have higher value than money tomorrow that is classic time value of money problem. Lastly, of course this answer is gross
– 1muflon1
Nov 19 '20 at 22:12
• @UtilityMaximiser in addition this simply cannot be correct: "Price of X" surely means "how many dollars can be exchanged for X,". Most problems in microeconomics do not even have money in them yet prices exists in those models. Prices exist in barter economies as well. Under such restrictive definition of price that would be impossible.
– 1muflon1
Nov 19 '20 at 22:23
• @UtilityMaximiser perhaps it could be technically more accurate to say not "the price of money" but "the price of borrowed money", but in common terms we omit this implicit assumption that we're talking about lending (as opposed to e.g. forex) for the sake of brevity. The price of 1 dollar is 1 dollar, but the market price price to rent 1 dollar for a year can be variable, of course. Nov 20 '20 at 11:05
• You two are having a silly argument over semantics. Clearly the price of money is tautological (the price of \$1 is \$1) but the expression is not used literally. A more precise term for interest rate would be cost of borrowing money, but this isn't so obviously connected to the supply/demand theory. Calling it the price of money is a useful shorthand. Nov 20 '20 at 13:00
• The value of money is surely related to the goods and services it can buy, so the "price of money" would be the reciprocal of the price level. The reason I dislike referring to interest rates as the "price of money" is it quickly leads to paradoxes. First paradox: how is it that general equilibrium models with no money nevertheless have interest rates. Second paradox: if the central bank creates new money and gives it to people who prefer to consume the new money rather than save it, the effect will be a rise in interest rates. This makes no sense if interest is viewed as the price of money. Nov 20 '20 at 13:38

I will give a rather oversimplified finance side version (macroeconomic version requires a lot of details).

Generally new money is injected in the economy by the central bank by buying government bonds from the market. These bonds can be assumed to have a fixed coupon payment. The price of the bond in the secondary market is dynamic such that annual coupon payment per year ($$c$$) divided by current market price ($$p_t$$), gives the interest rate ($$i_t$$). Clearly, as $$p_t$$ increases, $$i_t$$ decreases and vice versa.

To inject more money, the central bank starts buying these bonds which pushes their price up and consequently decreases the rate of return on the bonds.

How does this affect other interest rates? Well all investment avenues are imperfect substitutes. So as rate of return on one decreases, so does that of others. Portfolio managers would divert investment to other asset classes and as their demand goes up, returns fall until a new equilibrium is established in which returns on most (if not all) assets are lower.

• +1, though "Generally new money ..." looks to me like quantitative easing. Another route when interest rates are not absurdly low is that central banks can encourage the private creation of new money by reducing interest rates so new private borrowing is more attractive: the causal link between interest rates and money is in a sense then reversed. The central bank could often change interest rates by announcement, and would only have to undertake financial operations if the market failed to respond Nov 19 '20 at 10:25
• @Henry: That's an important point! If I understand correctly, if central bank decreases interest rates (through some policy instrument), speculative demand for money comes down which allows more (of the hoarded) money to come into circulation in the economy - effectively increasing money supply. Does this sound correct? Nov 19 '20 at 10:33
• This is a good answer but I'd like to add one thing: there is no necessary connection between changes in the money supply and (real) interest rates. The fact that new money tends to lower interest rates is merely a feature of the way central banks change the money supply in practice. But if the central bank printed a load of money and gave it to people who preferred to consume rather than save, the short-term result would be a rise in interest rates. Nov 19 '20 at 22:06
• @UtilityMaximiser: which is exactly why I have mentioned that macroeconomic version requires a lot of details. Nov 20 '20 at 3:37
• The interest rate and money supply link is fundamental and does not necessarily rely on bond markets or the existence of any central bank policies - they are linked also in pre-central bank times, without any bonds involved, for example in historical precious-metal based economies any major changes to the supply of (for example) silver had an appropriate effect on interest rates. Nov 20 '20 at 11:09

Here’s my Average Joe, fewest words, attempt: the more of a good circulating in the market, the less scarce is that good, and the lower the cost becomes. If money is the good, interest is the cost of borrowing.

When there’s not that much money on the market, in order for me to lend it to you, I have to re-allocate that money from a different place where it is being used (savings, investments, whatever). You, in turn, promise to pay me a bit more to convince me to do so (higher interest). As there’s not much money on the market being lent to people, you don’t have as many options so you’re willing to take on the higher costs.

When the money supply suddenly goes up, I can keep all my savings and investments where they are and still lend to you (but presumably, everyone else is also doing that) so to convince you to borrow from me, the rate I charge you has to goes down.

In an inflationary regime, money becomes one of the least valuable assets you can own. A ton of steel bought today will still be a ton of steel in a month, but the \$750 that buys a ton of steel today won't be enough to buy a ton of steel next month. Assets have their own depreciation and costs of ownership, but the greater the rate of inflation is, the more attractive everything else looks compared to money.

Banks, of course, have piles of money, and they would like to charge as much interest as they can to lend it out (that's how they make money on money). But lending is a market; banks with lower rates will attract more borrowers, and banks with higher rates will attract fewer. So they cut their rates in order to attract borrowers who will hopefully invest their money in something, make a return, be able to afford to pay back their loan with interest, and make the bank at least a small profit. Whoever doesn't cut their rates is left sad and alone with a steadily devaluing pile of money. In a low-inflation or deflationary situation, the bank doesn't feel so bad about holding on to a pile of cash (or treasury bonds), so demand from borrowers is able to drive the interest rate up.

• Lower inflation = higher interest rates? Reality doesn't seem to agree Dec 2 '20 at 14:58

It should go up. More money means more inflation. Inflation requires higher interest rates to attract depositors who would otherwise spend the money before it lost more value.

There were times when people took any money they got and immediately went to spend it before it lost more value. Worst cases they had to use wheelbarrows to haul it to the store. Or they printed trillion dollar notes like zimbabwe did. So the velocity of money would go up and the interest rates would be sky high.

For you personally the money supply hurts you when it goes up as your money is worth less due to the law of supply and demand. With more money trying to buy same amount of goods prices will go up.