Does a Higher Rate
of Growth of the Money Supply Lower Interest Rates?
To answer the question
of Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? You
have to take a look at how interest rates are born into existence, a theory of
how this comes to fruition is laid out in the liquidity preference framework.
The liquidity preference framework examines the supply and demand for
money. the liquidity preference
framework illustrates interest rates will vary, in the case that the request
for money varies. There are currently
four conceivable things on interest rates in an increased money supply. Which
are the liquidity effect, the income effect, the price level effect, and
expected inflation effect? However, out of the four, the liquidity effect is
the only known method that specifies that a higher rate of the money supply
would lower interest rates.
The Liquidity Effect
Using the liquidity effect a higher rate of growth of the money
supply will lower interest rates. Interest rates decrease as soon as the money
supply rises simply due to the circumstance that money has become more
abundant. Therefore, the more abundant
the money supply is the lower interest rate will be, which is called the
liquidity effect and is the only method that specifies that a higher rate of
the money supply would lower interest rates. There are three different
possibilities in relations to the liquidity effect and its effect on interest. “the
liquidity effect becomes less important, interest rates are found to be sensitive
to income and price effects” (Michis,2015).
First, there is an instance
where the liquidity effect can override over all of the other effects in order
to get the interest rate to lower. This happens fast to lower, however as time
passes other effects begin to undo some of the declines. Due to the size of the
action in comparison to others, the interest rate will not return to its
Secondly, there is an
instance where the liquidity effect can be smaller than all of the other
effects, because of the expected inflation effect is slower moving because
expectations are slower moving to increase. In the beginning, the liquidity
effect causes interest rate to drop. However, the income price level starts to
increase the rate. Which happen due to the fact that these effects are
overriding, and the interest rate rises back to what it was in the beginning.
Another instance in relation to the liquidity effect is when the
expected inflation effect overrides and moves fast, this is due to the fact
that expectation raises when the rate of money increases. The expected
inflation effect will overrule the liquidity effect, which would cause interest
rates to rise. That leads to price level effects which cause interest rate to
rise higher than before.
In the research and study of the question does
a higher rate of growth of the money supply lower interest rates? The answer is
no. therefore, what should happen in an instance like this is that money growth
must be hindered to lower interest rates.” The evidence seems to indicate that
the income price level expected inflation dominates the liquidity effect, that
an increase in money supply growth leads to higher rather than lower interest
So, looking into the liquidity preference
framework and examining that the supply and demand for money will differ
interest rate lower interest rate for a while, where the will eventually rise
back to its initial level or potentially increasing. Things that should be
considered when deciding on which route to take to lower interest rates. Should
be based on the situation which method would give the favored outcome whether
it be in the present or in future.