Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Changing the money supply affects the interest rate


The demand and supply of money determines the equilibrium interest rate, and the central bank controls the supply of money (see the preceding section). Therefore, the central bank can change the interest rate by varying the money supply:


To reduce the interest rate, it increases the money supply.


To increase the interest rate, it reduces the money supply.

In Figure 10-2, initially the supply of money corresponds to S₀, which leads to an equilibrium nominal interest rate of i₀. When the central bank increases the money supply to S₁, it reduces the equilibrium interest rate to i₁, because at the original interest rate (i₀) more money is now being supplied than demanded. This puts downward pressure on the price of money (the interest rate), causing the interest rate to fall to i₁ and bringing the money market

back into equilibrium.


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Figure 10-2: Varying the money supply.

Similarly, the central bank can increase the interest rate by reducing the money supply to S₂, leading to an equilibrium interest rate of i₂. The rate increases because at the original interest rate (i₀) more money is now being demanded than supplied, putting upward pressure on the price of money (the interest rate). Therefore, the interest rate rises to i₂ and brings the money market back into equilibrium.

Influencing the money supply: Open market operations
In practice, the central bank varies the money supply using open market operations. These involve the bank going to the government bond market and buying and selling government bonds (see Figure 10-


3):


To increase the money supply, the central bank buys up some of the government bonds in circulation, paying for them with money. In doing so, it increases the amount of money in circulation.

To decrease the money supply, the central bank sells some of the government bonds that it holds in return for money. In doing so, it

decreases the amount of money in circulation.


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Figure 10-3: Open market operations.

The effects that open market operations have on the money market change the equilibrium interest rate as shown earlier in Figure 10-2.