Does a higher growth of money lead to lower interest rates?

Introduction

Money supply and interest rates are among the simplest concepts in macroeconomics and describe the
correlation between them. This essay will also involve the analysis on how a rise in the money supply
results in a decline in interest rates in relation to graphical analysis and economic theories.

The interest rate corresponds with the conditions of the economy of a given country, where a higher or
lower level creates a positive or negative impact. Hence the result high or low in the interest rate will
significantly impacts on the economy. Higher interest rates will help to direct the funds to the bank
instead of the industrial activities while the increased probability of inflation can be controlled. However,
when the interest rate goes down people tend to hold more money from the saving in banks and this
leads to a situation that money supply goes up. This makes the price of goods will increase because an
increase in wages comes with an increase in the price of goods to be produced as more costs are
incurred to keep production running hence affecting the price of the goods to be sold in the market.

Theoretical Framework

One of the critical theories in understanding the relation between the money supply and the interest
rates is the liquidity preference theory proposed by John Maynard Keynes. According to Keynes, the
demand for money is influenced by three motives: that includes the necessary, accidental, and
convenience balances. When there is an increase in money supply, this leads to an increase in the
availability of liquidity in the economy and thus lower interest rates which encourages Banks as there is
increased funds that they can lend (Keynes, 1936). As the loanable funds theory claims that the rate of
interest depends with the availability of funds for borrowing and lending. This is because, Wicksell (1898)
hypothesized that an increase in the money supply increases the supply of loanable funds thus, shifting
the supply curve rightward and therefore a reduction in the equilibrium interest rate.

Fig:1.1 Fig:1.2

Liquidity Preference Theory by Keynes, 1936 Loanable Funds Theory by Wicksell, 1898

Several researchers have undertaken analyses that shows the existence of the theoretical relationship
between money supply growth and interest rates. Such as, Bernanke and Blinder, 1992 confirmed that
the greater supply of money leads to a lower short-term interest rate. Moreover, Taylor (1993) showed
that variations in money supply affect interest rate decisions and this actually holds in the short-run.
Graphical Representation

In order to envision the relationship between interest rate and money supply, I have considered a simple
supply and demand graph for the money market:

Figure:1.3

Money-Market Model

The above figure:1.3 shows, interest rate on y axis and Quantity of Money on x-axis. MS is the Original
Money Supply and MS’ is Increased Money Supply, Money Demand is determined by Md. Initially, the
equilibrium interest rate is at point e, where the original money supply curve (MS) intersects with the
money demand curve (Md). When the central bank increases the money supply, the money supply curve
shifts to the right (MS’). The new equilibrium is at point e’, resulting in a lower interest rate (i’) compared
to the original rate (i).

Impact on the Economy

Low interest rates mean less cost of capital, through borrowing business organizations are able to fund
capital projects. The outcome of this may result in the growth of the economy and employment
opportunities (Blanchard & Johnson, 2013). Lower interest rates also apply less pressure on the cost of
funds for consumers and this in turn promotes spending on the various materials and services. Such an
increase in the quantity of consumption becomes an economic growth driver (Mankiw, 2020).

Despite this, the increase in the volume of money supply helps in boost of economic activities although
with risks. Some of the challenges are; Inflation is a major factor that has always been a threat as
governments give out promissory notes. Consequently, the aggregate money supply if enhanced at a
faster pace it normally puts pressure on the price level in an economy. There is always the challenge for
central authorities with regard to overseeing monetary policies with the objective of kick-starting the
economy and on the other hand preventing inflation (Friedman & Schwartz, 1963).

Conclusion

Therefore, the findings showed that an increase in money supply leads to a decrease in interest rates. On
theoretical level, this relationship is backed up by the relevant theories or concepts of the theories while
on empirical level, there is ample evidence to support this relationship. Central banks apply different
measures of controlling the money volume, as well as interest rates which also have impact on the
overall economy. Nevertheless, the probable risks as the inflation require proper regulation of monetary
policy.
References:

Bernanke, B. S., & Blinder, A. S. (1992). The Federal Funds Rate and the Channels of Monetary
Transmission. American Economic Review, 82(4), 901-921.

Blanchard, O., & Johnson, D. R. (2013). Macroeconomics (6th ed.). Pearson.

Dornbusch, R. (1976). Expectations and Exchange Rate Dynamics. Journal of Political

Economy, 84(6), 1161-1176.

Friedman, M. (1968). The Role of Monetary Policy. American Economic Review, 58(1), 1-17.

Friedman, M., & Schwartz, A. J. (1963). A Monetary History of the United States, 1867-1960.
Princeton University Press.

Goodfriend, M. (1991). Interest Rates and the Conduct of Monetary Policy. Carnegie-Rochester
Conference Series on Public Policy, 34, 7-30.

Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. Macmillan.

Mankiw, N. G. (2020). Principles of Economics (9th ed.). Cengage Learning.

Mishkin, F. S. (2019). The Economics of Money, Banking, and Financial Markets (12th ed.).
Pearson.

Taylor, J. B. (1993). Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference

Series on Public Policy, 39, 195-214.

Wicksell, K. (1898). Interest and Prices. Macmillan.