Chapter 14: Problem 14

Suppose the money supply rises. Is the interest rate guaranteed to decline initially? Why or why not?

Short Answer

Expert verified

While an increase in money supply often leads to a decrease in interest rates due to increased liquidity, it isn't guaranteed. Other economic factors, especially expectations about inflation, could influence lenders to increase interest rates instead.

Step by step solution

Understanding Money Supply

Money Supply refers to the entire stock of currency and other liquid instruments in a country's economy as of a specific time. The money supply can include cash, coins, and balances held in checking and savings accounts.

Understanding Interest Rates

Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). These rates affect how much it would cost for entities (such as individuals, businesses, and governments) to borrow money.

The Relationship Between Money Supply and Interest Rates

An increase in money supply usually leads to a decrease in interest rates. This happens because when there's more money in circulation, individuals and businesses can access loans more easily due to increased liquidity in the banks. This increased availability of money often leads to lower interest rates, as banks don't need to charge as much to lend out their funds.

Exception to the Rule

However, it's not always guaranteed that the interest rates will decline initially because it would depend on other economic factors. For example, if inflation is expected to rise significantly, lenders may increase the interest rates to compensate for the loss in purchasing power of the money they will be repaid in the future. Therefore, it's not always a certainty that an increase in money supply will immediately lead to a decline in interest rates.

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