I’m going to talk this week about money supply, how interest rates affect money supply and how this impacts the rest of the economy. Going to try and write it simply so that people who find economics tricky can understand it – like Mr. Greenspan. I have a lot to comment about both America’s current interest rate policy, as well as the policy right here in South Africa (the next interest rate decision here is tomorrow). I want to make sure everyone understands the fundamentals before tackling those. If you know this stuff already, you can skip this one 
Now there are all sorts of graphs, formulas and theories that economists will baffle you with if you ask about money supply, but it is actually quite simple. Just think of money like any other good that can be bought and sold with a supply and a demand. And now think of the interest rate being the equivalent of the price of that good. So basic supply and demand principles in a free market:
- If the price of a good is low, lots of people will want to buy it (high demand), whilst factories will be less inclined to produce it because they make smaller profits (low supply).
- If the price of a good is high, fewer people will be able to afford it (low demand), whilst factories will want to produce lots of it because they make big profits (high supply).
- If demand is greater than supply, the good is going to be harder to find in the shops, people are going to be willing to pay extra just so they can get their hands on the good (increase in price).
- If supply is greater than demand, shops are going to have stocks piling up on their shelves and will start lowering prices to try and get people to buy more goods (decrease in price).
- Prices change until demand is equal to supply.
Right, now the same thing, but translated so it talks about money:
- If interest rates are low, lots of people will want to borrow money, whilst fewer people will be willing to lend/save money because the return is low.
- If interest rates are high, people can afford to borrow less money (I’m sure there are a few people sweating about this right now), whilst people will want to lend/save money because the returns are good.
- If more people want to borrow money than people want to lend/save (demand>supply), it is going to be tough to get a loan, so people will be willing to pay a higher interest rate to secure their loan (increase in interest rates).
- If more people have excess money that they want to lend/save and fewer people want to borrow money (supply>demand), then they will be willing to accept a lower interest rate, just so they can get some return on their money (decrease in interest rates).
- Interest rates change until demand is equal to supply
But why you ask are we talking about interest rates changing on their own, when we all know that a bunch of grey-beards get together every now and then and decide what interest rates should be (as Tito and co are doing right now). Well this is where money differs from all other goods. Money is the good that is used to buy other goods and made by selling other goods. And because of this money supply will directly affect the price of other goods. If you give a hundred people $1 million dollars, they will all rush out and attempt to buy a Porsche, however there are only 10 Porsches. So the price of a Porsche will go up as the people fight to get hold of one. Increasing money supply without increasing the supply of goods results in increasing prices (inflation). So money supply influences inflation, and can be used to control inflation. Supply more money and inflation goes up. Print way too much money too quickly and inflation skyrockets (like Zimbabwe). Supply less money and inflation goes down. Fail to print enough money and you get deflation (falling prices). Falling prices? Wouldn’t that be great? No! Deflation is one of the worst things to happen in an economy. How would you feel if your company gave you a decrease? If your company profits kept falling? If your house was worth less every year? Deflation can end up demoralising an economy – a reminder that economics is really about people and perceptions. And I have to mention one other impact at this stage – in the above Porsche example, Porsche is going to start making more Porsches because of the extra demand. So increasing money supply can also spur economic growth, and conversely restricting money supply can result in economic decline (deflation as mentioned above being the extreme example).
Remembering the basics mentioned earlier, you will see that money supply affects both the price of money and the price of other goods. Increasing money supply (without an increase in demand) will cause interest rates to fall and the price of other goods to increase. Now the poor central bank/reserve bank is the beginning of the money supply creation process and it is the central bank’s job to manage money supply in such a way that it doesn’t make either interest rates or inflation get out of control. With so many different factors and influences, it is a virtually impossible job to determine the correct money supply that will result in reasonable inflation and interest rates. So the central bankers got clever - as money supply affects interest rates, so too do interest rates affect money supply. If the price of money is too high (high interest rates), fewer people are going to demand it (borrow it). So instead of trying to control money supply, the central bankers control interest rates instead, and basically supply whatever money ends up being demanded. So if you follow the chain – increase interest rates, decrease demand for money, decrease supply of money, decrease inflation. Or decrease interest rates, increase demand for money, increase supply of money, increase inflation. Now the central banker can control inflation by controlling interest rates and not have to worry about how much money to supply.
And that is how interest rates, money supply and inflation all fit together. All very simple and easy. Unfortunately assuming that something as fundamental to an economy as its money supply is simple and easy is going to end in someone getting hurt. Telling your central banker that all he needs to worry about is controlling inflation is not always a good thing. Likewise using interest rates and money supply to encourage growth in your economy doesn’t always have beneficial results. Everything I have described above has a million caveats, assumptions and problems associated with it… But I hope to tackle some of those next time.
19 responses so far ↓
1 Christy // Apr 24, 2008 at 2:27 am
You should be a uni lecturer. If all of my tutorials were worded like this life would be so much easier.
2 Vuyisa Caleni // Apr 24, 2008 at 12:06 pm
I am BBA degree student and economics is one of my subjects. i find this website making things look very easy for me to understand the concepts of economics because it has been one of the subjects that give me headache. Now with your very simple explaination i would like to get more especially on the macro side of things because that’s where my course focuses.
3 Vuyisa Caleni // Apr 24, 2008 at 12:09 pm
It is explain very easy even an average person could understand economics with this kind of explaination.
4 Pete // Apr 24, 2008 at 6:22 pm
Hehe, economists love to hide stuff in graphs and equations and complex words, but at the end of the day economics is about people. One of the techniques of understanding economics is to think about what it means to you. How does an increase in interest rates affect you? What about inflation? Then multiply that by a few million people
I must warn you however, what I explained above is over-simplified and can therefore only be applied in very limited circumstances. A whole host of factors can have major impacts - no least of which is foreign exchange rates.
5 jayraj // Jan 16, 2009 at 9:13 am
Hi, what a clear and simple explanation . i really like it
Thanks.
6 Andrew // Mar 9, 2009 at 11:39 am
I have a question regarding this statement: “So instead of trying to control money supply, the central bankers control interest rates instead, and basically supply whatever money ends up being demanded.”
How exactly is the money supplied? For example, assuming that banks have lent out the maximum they can lend (as determined by their reserve ratio’s). How can they lend more simply if interest rates decrease and people demand more money?
Thanks in advance.
Andrew
7 Pete // Mar 9, 2009 at 10:00 pm
The price of bonds is inversely proportional to interest rates. If interest rates increase, bond prices decrease, if interest rates decrease, bond prices go up. This is because the regular payments (coupons) of bonds are fixed, so if interest rates are low, something that guarantees a higher payout is going to be worth more.
Right, so the reserve bank operates through issuing and buying back bonds. If it lowers interest rates, bond prices will go up. Banks holding those bonds will therefore have an improved reserve ratio, because their reserves are made up of bonds. The bank will therefore be able to sell the extra bonds to bring their reserves down again, creating more free capital which they can lend out.
Does that make sense? It is a bit of a short answer.
8 Andrew // Mar 10, 2009 at 4:37 pm
That is a very clear answer. So to summarize the can increase the money supply in two primary ways:
1) Interest rates: Decreasing the interest rates increases the value of the bonds and hence the value of bank reserves, allowing them to lend more
2) Qualitative easing: Print money and get it into circulation by buying government bonds back from the market
Thanks a million, you do a great job of putting this into a language we can all understand!
9 Kurian Job // Apr 6, 2009 at 5:15 pm
Is the fall/hike in interest rates proportional to the hike/fall in bond pricing?
If yes,where will i be able to finnd it?
10 Pete // Apr 13, 2009 at 12:12 pm
At a very simple level, yes, they are proportional.
However in most markets bond pricing moves freely and will anticipate interest rate movements. So if people believe that interest rates are going to come down next month they will factor that into the price they offer/ask for bonds.
Also bonds have different life spans. The price of a bond that matures in 20 years should take into account any anticipated interest rate movements from now till 20 years time, whereas a bond that matures in a month will only take into account interest rate movements in that month. If you put all the different length bonds together you get what is called a yield curve. A yield curve is a good indicator of what the market expects interest rates to do over a period of time.
11 tayo // Apr 26, 2009 at 11:42 pm
this is really good i feel less like an idiot.thanks
12 Phil // Jul 2, 2009 at 5:24 pm
How is the U.S. able to keep interest rates down when the Government is pumping money into the economy? It would seem with the low interest rates and the trillion dollar bailouts that these would increase inflation.
13 Pete // Jul 16, 2009 at 2:16 pm
Going into a recession, you get very strong deflationary pressures. People find it harder to sell stuff, so they are forced to lower their prices. Companies have smaller profits and cannot afford large wage increases. People are also desperate for work and so will work for less money. All of this keeps prices down.
It is actually generally a good idea to increase government spending when entering a recession, as you actually want some inflation to counteract the falling prices of a recession and to keep money and goods flowing. America unfortunately already has huge amounts of government debt and so increasing government spending comes at a high future cost.
There are actually two options for America - increase government spending now and have a longer, but less severe recession (and a longer recovery period); or minimise government spending now, have a very severe recession, but get your finances back under control and have a rapid recovery period and greater future growth… tough choice.
14 leen // Nov 24, 2009 at 8:46 pm
If money supply increased, then inflation increases, so shouldnt nominal interest rate increase too?
15 Pete // Nov 24, 2009 at 10:25 pm
Interest rates are controlled, they only increase/decrease when the central bank decides. If you have an increase in money supply and you leave interest rates fixed, you will probably get inflation. If you increase interest rates, this will counteract the inflation and reduce the amount of inflation you got with the increase in money supply.
16 jayraj // Nov 30, 2009 at 8:53 am
i understood the relation between interest rates and money supply thanks for such an easy explanation. I am MBA finance student and i want to know how interest rates in turn affects exchange rates and vice versa. pls give me some example explaining the concept.
17 Pete // Nov 30, 2009 at 6:39 pm
The relationship between interest rates and exchange rates is a highly complex one. But the very simple explanation is that if you raise your interest rates, your currency strengthens. This is for two reasons, local demand for goods drops so imports will also drop; and second because overseas people are attracted to invest into your country by the higher returns. So higher interest rate = fewer imports, better current account + more investment, better capital account = stronger currency. And the opposite applies: lower interest rate = more imports, less investment = weaker currency.
But that’s the easy textbook answer. The reality is way more complicated, where relative interest rates, interest rate cycles, relative sizes of import and export markets, credit ratings and political risk all play a part. And all sorts of long term adjustments can happen.
18 pkw // Feb 19, 2010 at 11:06 am
before the election time period, why central banks tend to lower interest rate to increase money supply and sell foreign exchange reserve at the same time?
19 Pete // Feb 19, 2010 at 7:46 pm
If you lower interest rates, you make everyone with debt happier. Also lowering interest rates stimulates spending, giving the overall economy a little bit of a boost.
So people’s debt is cheaper and the economy looks better - everything to make the government look good.
But lowering interest rates will make your currency weaker (see above for explanation), this would make imported goods more expensive and would make people unhappy with you. But if you sell your foreign exchange reserves at the same time, it will strengthen your currency (you are selling the foreign currency and buying your own currency) and counteract the effect of the lower interest rates.
Leave a Comment