Why does a decrease in the money supply cause an increase in interest rates?

Answer 1

It is important to distinguish the cause and effect of the two variables - you are asking why a decrease in money supply leads to an increase in interest rates, and the replies have so far been telling you why an increase in interest rates leads to a decrease in money supply.

So, can you change the money supply to have an effect on interest rates? Yes. Let's see what happens.

First, you have a decrease in money supply. This is usually the result of a central bank policy (although we shall not go into how exactly they do this - might be confusing). Assuming that we are in the short run, prices are given (i.e. do not change) and money demand remains the same. Now, there is a disequilibrium in the money market, where money demand is greater than money supply.

Keeping that in mind, we now look at the initial equilibrium interest rate, r*. Now, at this current interest rate, people are holding less money than they desire, so they sell their assets (that pay interests) to have greater liquidity. However, as we have mentioned earlier, money demand is greater than money supply, there will be more people wanting to sell assets to obtain liquidity than people willing to buy assets and giving up liquidity.

As a result, the interest rates get pushed up slowly, so as to reflect the market mechanism of creating a greater incentive for people to hold on to / buy assets. The interest rate will then rise to a point where there are equal number of assets being bought / sold. At this same point, money demand would also have decreased to match the lower money supply.

Hope that helps, and let me know if it doesn't. It probably means I wasn't clear enough.

Answer 2

A Decrease In Supply Means

Answer 3

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Why does a decrease in the money supply cause an increase in interest rates?

Answer 4

Money Supply And Interest Rates

Answer 5

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a. Value of US dollar will increase since a decrease in supply coupled with no change in demand leads to a higher price. Not sure what the question means by "foreign dollar." But since the supply of "foreign dollar" will increase and assuming demand is constant, then we reach a lower equilibrium price and higher quantity. b. Well, if interest rates increase then that decreases aggregate demand because consumption will decrease due to a) it will now be more difficult to borrow money & b) the money consumers already owe now costs more to pay back. Secondly, investment will decrease since the cost of borrowing money has increased. Vice versa for when interest rates decrease.

Answer 6

In economics when interest rates increase, investment decreases and saving increase. People don't borrow money as much when there is a high interest rate, but save more. So there is a decrease in the money supply, because people aren't borrowing (aka spending) for houses, cars, etc. Economic growth occurs when people spend money, not save. It's a complicated cycle for me to explain without the use of graphs/models :)
===>Just know that as interest rates increase spending decreases.
===> As spending decreases, less money will be seen flowing throughout the economy. So we have a decrease in the money supply.

Answer 7

decrease in money supply will not cause in increase in interest rate. It should be oppose. Too high money supply will cause inflation, simplily means very high price for overall product on the market. Inflation is an economic problem. To solve the problem, US government usually raise the interest rate. When interest rate raised, people will spend less money and save it into bank. People invest less into stock, bond since those return is relatively decrease. As people spends less money in the market overall, the money supply will decrease. Of course the inflation may release, too.

Answer 8

In my point of view..., money supply decreases means there is less flowing of money in the economy... People have less money than the desire so people borrow money from the bank and bank increases the interest so that they will earn the earn.

Answer 9

This is a chance for you to apply the law of Supply and Demand.

Answer 10

no a decrease in money supply would result in the increase ed value of $'s.
One dollar would buy a lot more that it can currently buy.