The supply of money is chosen by the monetary authority and is independent of the interest rate. Thus it is drawn as a vertical line. The equilibrium in the money market is shown in Figure 16.17 “Money Market Equilibrium”. Thus the LM curve is upward sloping: higher real GDP is associated with higher interest rates.
How does tax rate affect money supply?
Governments can increase spending by increasing taxation, selling additional bonds to the public or increasing the money supply. The government then sells bonds to the public creating an excess of borrowers over lenders. This in turn increases the interest rate to bring us back to equilibrium.
How does bank rate influence money supply?
The RBI can influence money supply by changing the rate at which it gives loans to the commercial banks. By increasing the bank rate, loans taken by commercial banks become more expensive; this reduces the reserves held by the commercial bank and hence decreases money supply.
What happens when there is an excess supply of money?
When there is an excess supply of money, there is excess demand for bonds. So, the Fed will issue new bonds. Customarily, when there is an increase in the supply of money, there is an increase in consumer spending. In return, there is a decline in interest rates hence, increasing total demand.
How does the supply of money affect the interest rate?
Changes in the Supply of Money When the Federal Reserve adjusts the supply of money in an economy, the nominal interest rate changes as a result. When the Fed increases the money supply, there is a surplus of money at the prevailing interest rate. To get players in the economy to be willing to hold the extra money, the interest rate must decrease.
What happens when the Fed changes the money supply?
It is important to realize that by controlling the money supply, the Fed changes interest rates. When the money supply is changed, interest rates follow. However, the Fed’s decision to change the money supply is not the final determining factor of interest rates.
How are money supply and demand and nominal interest rates determined?
Nominal Interest Rates and the Market for Money. Like many economic variables in a reasonably free-market economy, interest rates are determined by the forces of supply and demand. Specifically, nominal interest rates , which is the monetary return on saving, is determined by the supply and demand of money in an economy.
How does contractionary monetary policy affect interest rates?
In contrast, contractionary monetary policy (a decrease in the money supply) will cause an increase in average interest rates in an economy. Note this result represents the short-run effect of a money supply increase. The short run is the time before the money supply can affect the price level in the economy.
