Money supply: Macroeconomic Implications of Money Supply Growth
Money supply: Controllability of Money Supply
The second major macroeconomic issue surrounding money supplies is their impact on interest rates, exchange rates, output, and the overall price level. In theory, and subject to many simplifying assumptions, when a country’s money supply increases, short-term interest rates will fall in the short run, the exchange rate (in terms of units of domestic currency needed to buy one unit of foreign currency) will rise in the short run, output will rise but perhaps not permanently, and in the long run, overall prices will also rise. The rationale for these effects is that the economy’s demand for money depends in the short run negatively on interest rates and in the long run positively on output and overall prices. In the short run, interest rates will fall in order to raise money demand to the new level of money supply, and as a result, the price of foreign currency will rise. In the long run, nominal income which is the product of output and the price level will rise. Other things being equal, the increase in nominal incomewill cease when money demand has increased sufficiently tomatch the initial rise in money supply. Interest rates and exchange rates will return to their previous levels.
This simple scenario becomesmore complex once we consider the dynamics of interest rate and price adjustments between the short run and the long run. In themediumrun, the fall in interest rates as well as the increased availability of money for spending will cause macroeconomic demand to increase. This will induce more output that is, more production of goods and services. The rise in the exchange rate will also increase foreign demand for the country’s exports, which will induce a further increase in output. Whether this output increase is temporary or permanent will depend on whether inputs so-called ‘‘factors of production’’ like labor and capital are already fully employed. If workers are unemployed and factories are operating at less than full capacity, output can increase permanently. Otherwise, the effect of an increasedmoney supply in the long run is simply to raise prices.
More realistically, we should consider increases in the rate of growth of the money supply, rather than simply its level. In the short run, until factors of production are fully employed, increasing monetary growth increases the rate of increase of output. In the long run, increasing monetary growth increases the rate of increase of prices that is, it increases the inflation rate rather than the level of prices per se. Long-run interest rates, which rise with expected inflation, will also rise.