Effect on Interest Rates
As seen in the money market graph of Chapter 8, the money supply has a
direct effect on nominal interest rates in an economy. When the money
supply increases, the supply curve shifts to the right and the nominal
interest rate decreases. When it decreases, the supply curve shifts left
and nominal interest rates increase. Thus, for easy money actions, the
increases in the money supply cause interest rates to decrease. With
lower nominal interest rates, loans become less costly. Businesses then
use these lower interest rates to invest and expand, causing economic
growth. For tight money actions, the money supply decreases causing
interest rates to increase. Higher nominal interest rates cause loans to
become more expensive, consequently causing businesses to expand less.
This creates a slowdown in the economy. The effects can be seen on the
graphs below.
Money Multiplier
When money enters the money supply, it can have an ever greater effect on the quantity of money than its own value. To estimate and evaluate the effect of an expansion in the money supply, economists use the money multiplier. The money multiplier is the total maximum expansion of the money supply by a single value of money. It exists on the assumption that banks loan out all of the money available as excess reserves and no money is held outside the bank. (e.g. no money is placed in financial investments or held onto as cash.) In reality, this situation is highly unlikely. To calculate the money multiplier, we use the following equation:
Money Multiplier = 1/(Reserve Requirement)
We can then use the money multiplier to calculate the total maximum quantity expansion of money in the economy by the next equation.
Expansion of Money Supply = Money Multiplier x Excess Reserves
*It is important to note the special exception of this equation for new money. (Recall that new money is created when the FED buys bonds on the open market.) The equation remains the same but the quantity of new money must be added to the total expansion of the money supply as follows:
Expansion of MS = (Money Multiplier x Excess Reserves) + New Money
This occurs because the new money is not considered a part of the bank’s reserves. In order to be a reserve, the money must have been received from a customer’s depos
When money enters the money supply, it can have an ever greater effect on the quantity of money than its own value. To estimate and evaluate the effect of an expansion in the money supply, economists use the money multiplier. The money multiplier is the total maximum expansion of the money supply by a single value of money. It exists on the assumption that banks loan out all of the money available as excess reserves and no money is held outside the bank. (e.g. no money is placed in financial investments or held onto as cash.) In reality, this situation is highly unlikely. To calculate the money multiplier, we use the following equation:
Money Multiplier = 1/(Reserve Requirement)
We can then use the money multiplier to calculate the total maximum quantity expansion of money in the economy by the next equation.
Expansion of Money Supply = Money Multiplier x Excess Reserves
*It is important to note the special exception of this equation for new money. (Recall that new money is created when the FED buys bonds on the open market.) The equation remains the same but the quantity of new money must be added to the total expansion of the money supply as follows:
Expansion of MS = (Money Multiplier x Excess Reserves) + New Money
This occurs because the new money is not considered a part of the bank’s reserves. In order to be a reserve, the money must have been received from a customer’s depos
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