Changing the Supply of Money

Lets see how changes in the supply of money effect the interest rate.

Figure 2(repeated): Liquidity Preference and a Change in the Money Supply

1. Suppose that the rate of interest is R_b, the money supply is M_b, and the Federal Reserve authorities want to raise the interest rate to R_a. They would do this by cutting the money supply back to M_b. At the going interest rate of R_b, people would want to hold more money than that, so they would sell some of their bonds to get more money. But with no more money to be gotten, their competition to sell bonds would just push the price of bonds down and the interest rate up. Thus the interest rate would rise to R_a, and at that rate, people would be satisfied to hold the reduced supply of money and would not compete to sell any more bonds at even lower prices.

2. Suppose that the rate of interest is R_a, the money supply is M_a, and the Federal Reserve authorities want to reduce the interest rate to R_b. They would do this by increasing the money supply to M_a. At the going interest rate of R_a, people would want to hold more bonds, so they would compete to buy bonds with their increased money balances. But with no more bonds to be gotten, their competition to buy bonds would just push the price of bonds up and the interest rate down. Thus the interest rate would drop to R_b, and at that rate, people would be satisfied to hold the increased supply of money and would not compete to sell any more bonds at even higher prices.

Adjusting for Inflation, Again