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Using the liquidity effect and income effect, explain the outcome on interest rates of a higher rate of growth of the money supply

Using the liquidity effect and income effect, explain the outcome on interest rates of a higher rate of growth of the money supply

FINANCIAL ACCOUNTING
FINANCIAL ACCOUNTING
10th Edition
ISBN:9781259964947
Author:Libby
Publisher:Libby
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
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Using the liquidity effect and income effect, explain the outcome on interest rates of a higher rate of growth of the money supply

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All else being equal , a larger money supply lowers market interest rates , making it less expensive for consumers to borrow . Conversely , smaller money supplies tend to raise market interest rates , making it pricier for consumers to take out a loan .

An increase in the money supply can have two effects:

(i) it can reduce the real interest rate (this is called the “liquidity effect”, more money, i.e. more liquidity, tends to lower the price of money which is equivalent to lowering the interest rate)

(ii) it forecasts higher future inflation

 

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