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I'm currently working through the textbook Macroeconomics: European Perspective. I'm on chapter 4: financial markets. I'm struggling with the intuition for why increases in the central bank money supply decreases the interest rate.

If we set the model up as:

$M^d = £Y\times L(i)$, where $M^d$ is the model demanded, $£Y$ is the nominal income level, and $L(i)$ is the function of interest rates (which decreases as they rise) that relates the two.

Then at equilibrium, we know that the money supply, $M^s$, must equal the money demanded $M^d$, which gives us:

$M^s= £Y\times L(i)$

On this basis if we hold the level of nominal income fixed $£Y$, then an increase in the money supply $M^s$, will increase $L(i)$, which is achieved through decreasing the interest rate $i$.

That's all straightforward as it goes.

However, I struggle to understand the intuition for this. If we had a simplified situation where consumers and banks can either hold currency or bonds, then I understand that increasing the interest rate increases the incentive to hold bonds and therefore decreases the demand for the supply of currency. The opposite obviously follows with decreasing interest rates.

I also follow that if we increase nominal income, then we increase the demand for transactions and therefore currency. To keep demand for currency at the level before nominal income increased, an increase in the interest rate is needed.

But if we are at equilibrium and we increase the money supply, I don't get a feel for why the interest rate must fall?

Thanks for any help,

Hmmm16

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  • $\begingroup$ Ok, so I think this may actually be even more obvious than I expected. If we are at equilibrium and we increase the money supply, then to get back to the new equilibrium we need to 'incentivise' the demand for more money so that $M^s = M^d$. We do that by decreasing the interest rate which makes holding bonds vs currency less attractive. $\endgroup$
    – hmmmm
    Nov 13, 2022 at 21:23

1 Answer 1

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Because if you hold demand constant and increase supply of anything, money included, only way how you can clear the market is to decrease price. We assume that at the original price market did clear. Consequently, the customers would not be willing to purchase higher quantity without lowering the price (unless the demand is perfectly inelastic or elastic). In money market interest is the price of money.

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