Question

According to liquidity preference framework, in what direction do interest rates move in response to an increase in money supply, other things unchanging? What is the name of this effect?

Answer 1

The increase in money supply leads to a decrease in interest rate, this makes it affordable for the consumers for borrowing and other things remain constant, i.e., unchanged. This increases the investments, and by putting more amount of money for the consumers, making them assume to be wealthier, and stimulating the spending of the consumer. The businesses respond to this situation by ordering more quantity of raw materials and try to increase in production.

The decreased interest rates reduce the ultimate cost of the borrowings. This helps to increase in investments and results in increase in profitability level and promotes economic activity. The consumers by getting affordable borrowings will lead to much greater disposable income. At the individual level the businesses, level and quantity of production relatively benefit and the overall economic stability of the economy. This effect is known as the effect of money supply.