Question

⦁ Explain how the money supply and interest rate have changed over time. Explain the relationship between the money supply and interest rate.

Answer 1

• The money supply and interest rates, generally have an inverse relationship i. e as money supply is increased (easy monetary policy) it leads to fall in interest rates and as the money supply is reduced (contractionary monetary policy) it leads to higher interest rates.

This is so because the central bank changes the money supply (increase/decrease) through bond markets, which in turn effect interest rates. To increase the money supply, the central bank buys bonds (for money), this leads to excess demand for bonds and hence the higher bond prices. Higher bond prices means lesser interest rates (bond prices and interest rates are negatively related). Similarly, to decrease money supply, the central bank sells bonds, which leads to excess supply of bonds, and hence lower prices (and higher interest rates) in bonds market.

Bond price and interest rate is negatively related because a bond carries a fixed coupon rate (say$10 on an $100 bond which is 10%) but as the price of a bond decrease, the interest rate has to increased in order to maintain the same coupon rates (in our example if price falls to say $90, then the required rate of interest will have to be more than 10% to pay.

The interest rate in US economy have been pretty low untill last year which show easy monetary policy on part of federal reserve. This is to support the growth rate of output in the economy.