Question

How can the money supply affect the interest rate? Explain briefly and show in the graph!

Answer 1

Answer to the following question:

Interest is the price that one has to give up in oder to keep cash in hand. Whenever, somebody wants to keep the cash in hand he has to give up the interest that he would get if he saved the money. So, When the money suppy is increased, given the demand for money constant then, an increase the supply of money will lead to a fall in the rate of interest.

Lets simplify the things, assume that the money is a commodity and producer (Supplier) is the central bank and those who demand the cash in hand will have to forego the interest rate (price). Now, the rate of interest is 6%, given the demand for money as contant, if the supplier(central bank) raises the supply of money this will lead to a fall in the rate of interest (fall in the price) to, say 5%.. Diagrammetically:

In the diagram we can seethat the Moned demand curve (Md) is down ward slopping and on the other hand the supply of money is vertical (exogenouslydetermined). The initial equilibrium is at point E1 where the money supply and money demand curves intersects each other. The equilibrium rate of interest is r1. Now suppose the supply of money is increased from Ms1 to Ms2 (given the demand for money as unchanged, the equilibrium will shift from E1 to E2 and the new rate of interest has declined from r1 to r2.

So, it can be concluded that, keeping the demand for money as unchanged, any increase in money supply lead to the fall in the rate of interest and vice versa.

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