1
$\begingroup$

For context, here is the graphic that my question is based on: enter image description here

It says when interest rates are low, an employee paid 100 dollars will spend all 100 dollars, and when interest rates are high, an employee paid 100 dollars will save 50 dollars and spend 50 dollars. But why do interest rates cause this change? It seems like a non-sequitur.

$\endgroup$
7
  • 1
    $\begingroup$ note: this is what Friedman argued, and not necessarily what is true. $\endgroup$
    – user253751
    Oct 20, 2022 at 21:19
  • 3
    $\begingroup$ @user253751 are you trolling? The fact that government can stimulate consumer spending by loose monetary policy outside ZLB is empirically as well established as that earth is round. Have you ever read anything about macro? You might as well say about Copernicus saying earth revolves around the sun, note: that is what Copernicus argued, and not necessarily what is true $\endgroup$
    – csilvia
    Oct 20, 2022 at 22:15
  • 3
    $\begingroup$ @csilvia "government can stimulate consumer spending". The question is about how the fed funds rate effects changes in the money supply, not consumer spending... $\endgroup$ Oct 20, 2022 at 23:01
  • 2
    $\begingroup$ @Timkinsella A) the question is referring to the picture about consumer spending B) That would still be trolling there is even more direct empirical evidence that low interest rates increase money supply and high contract it. For effect on consumption you actually have to do some fancy econometrics, but this is plain to see. Just make scatter plot of M2 and CB rate for any country... claiming there isn't a relationship is literally like saying earth is flat or only 5000 years old $\endgroup$
    – csilvia
    Oct 21, 2022 at 1:01
  • 1
    $\begingroup$ @csilvia the pictured argument is not just that interest rates affect consumer spending, but also that consumer spending affects the money supply, and specifically, that decreased consumer spending decreases the money supply. $\endgroup$
    – user253751
    Oct 21, 2022 at 16:49

3 Answers 3

1
$\begingroup$

How exactly do interest rates affect the money supply?

This is because lending expands the money supply. When interest rates are low demand for loans is higher and when interest rate is high demand for loans is smaller.

Interest rate can be actually thought of as the 'price' of money. It is what you have to pay to get x amount of currency. When price of something decreases, all things equal, people demand more of it.

It says when interest rates are low, an employee paid 100 dollars will spend all 100 dollars, and when interest rates are high, an employee paid 100 dollars will save 50 dollars and spend 50 dollars. But why do interest rates cause this change?

This is not change in money supply but change in consumer spending. At a higher rate of interest people want to save more. When interest rate per year is 20% you will try to save more than when interest rate is 1%.

However, this is not expansion of money supply, this is the effect that low interest rates and expansion of money supply have on aggregate demand.

Expansion of money supply and low interest rates is what leads to the chain showed in the infographic, but in itself is not visualized there.

PS: Also the infographics is misleading. This is not Friedman's monetarism, this is something that all mainstream economists accept whether they are monetarists or not. Rather monetarism is the idea that this (monetary policy) should be the primary tool that government should use to smooth out business cycles as opposed to using fiscal policy as the primary tool.

$\endgroup$
4
  • $\begingroup$ Comments are not for extended discussion; this conversation has been moved to chat. $\endgroup$
    – 1muflon1
    Oct 21, 2022 at 10:04
  • 1
    $\begingroup$ Re: "lending expands the money supply" ... hmmm, what if during the day banks lent out 2 billion in new loans but 3 billion of pre-existing loans were paid back. There has been some lending going on but the money supply shrank. $\endgroup$
    – Mick
    Oct 21, 2022 at 12:58
  • $\begingroup$ @Mick sigh obviously implicit in that statement is ceteris paribus assumption, you can never say x causes y without implicitly holding other things constant $\endgroup$
    – 1muflon1
    Oct 21, 2022 at 13:09
  • 1
    $\begingroup$ I see your point exactly, in general... but the importance of explaining that the money supply is all about new loans vs old repayments depends on how often the non-appreciation of this fact leads to errors in understanding. The number of articles I've read in the past ten years where people say words to the effect of "if the central bank does all this money printing then it must lead to inflation" is incredible. I'd guess that 99.9% of the population are unaware that bank loan repayments destroy money. $\endgroup$
    – Mick
    Oct 21, 2022 at 13:24
-1
$\begingroup$

There is a lot of misinformation and misunderstanding about the monetary system, even in textbooks! But since 2014 the Bank of England cleared up many of the misunderstandings with their paper Money Creation in the Modern Economy. The paper explains how money is continuously being created and destroyed. It is created when commercial banks make loans and destroyed when the borrowers pay back the principal on their loans. So the total money supply is a function of these two rates of flow. Rather like a tap pouring water into a bucket with a hole in it. The rate of flow of water from the tap corresponds to the rate at which new loans are being made and the rate at which water is running out of the hole corresponds to the rate of loan repayments.

Raising or lowering interest rates is an attempt to influence people's enthusiasm for taking out new loans, i.e. lower rates means more loans means a faster flow of water from the tap. I say "attempt" because it doesn't always work as planned. In Japan for example, after the big property crash in the 90's, the Bank of Japan lowered rates to zero (or there abouts) but even at that rate, people were still reluctant to take out new loans. This meant that Japan went through a long period of fighting against deflation (more water pouring out of the hole than coming in through the tap) with all those mortgages being repaid over decades.

$\endgroup$
8
  • 2
    $\begingroup$ The 2014 paper does not describe the current system but the system before recent rework at the end of 2010s and beginning of 2020s. It is bit hypocritical to say textbook spread misinformation and then posting paper that is no longer accurate because the system was reformed since its publishing $\endgroup$
    – WilliamT
    Oct 21, 2022 at 12:06
  • 1
    $\begingroup$ Indeed the system is changing all the time, but the paper is more correct than most, to this day. What single document would you suggest best describes our current system? And would you dispute the bucket with hole analogy? $\endgroup$
    – Mick
    Oct 21, 2022 at 12:36
  • 1
    $\begingroup$ @WilliamT what exactly in the linked article is so obsolete that it makes the claims in this answer untrue? $\endgroup$ Oct 21, 2022 at 18:05
  • 1
    $\begingroup$ @Timkinsella because relationship between interest rate and money supply did not change. If this answer would just stick to things that did not change that would be fine but saying that paper describes current system is incorrect. Also there is a difference between fundamental economic relationships/concepts such as supply and demand, and man-made monetary system that has certain rules. The relationship between interest rate and money supply holds in any monetary system because interest rate is always price of money and the inverse relationship between price and demand for non-Giffen goods $\endgroup$
    – WilliamT
    Oct 21, 2022 at 19:01
  • 1
    $\begingroup$ i don't see an answer to my question, but maybe i'm missing it @WilliamT $\endgroup$ Oct 21, 2022 at 19:03
-3
$\begingroup$

"why do interest rates cause this change?" Higher interest rates mean a higher return on savings and so they incentivize more saving. I think to understand Friedman’s argument beyond that point you have to

  1. understand how economists’ definition of “money supply” has changed and expanded over time and

  2. Ask “how is the $50 in the example being saved?”

Obviously if you just leave your "savings" in a checking account, it is not actually leaving the money supply (although that is clearly not what the argument intends since we are talking about interest rates). In Friedman’s day, if the $50 were put in a savings account, then it would in fact have been leaving the M1 money supply as it was then calculated. Since 2020, however, savings deposits have been incorporated into M1 by the federal reserve. M2 is the more common measure today, and it includes short term safe and liquid securities like treasury bills. Thus my 50 dollars doesn’t leave M2 if I use it to buy a treasury bill. What about M1? Well if I buy it from an institution with an account at the federal reserve, then my money really does vanish from M1 since it left my checking account and was not transferred to anyone else’s, though the institution I bought it from will receive the corresponding amount of reserves from my own bank. If I buy a longer term security then my money will also vanish from M2 in this way, although not from broader aggregates like M3 and M4.

It seems your confusion may have been more about how interest rates incentivize saving, so sorry if this answer fails to address that -- it was perhaps more me grappling with my own confusion about the argument.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.