Money Supply, interest rates question

WillPower · #1 11-29-2002, 06:18 PM

For those of you who sat for C2 recently you will remember this question.

What happens as a result of an increase in deficit (govt. spending) in terms of Investment, Interest rates and Output. I think the correct answer was output/income increases, so Interest rates go up, then Investments go down which means private savings go up blah blah

See, I really thought I understood this stuff because I also know or was told that an increase in interest rates will increase money supply.

But then, a govt purchase of bonds "creates money from thin air", and therefore, increases the money supply. Govt buying bonds implies the price of bonds will go up which means interest rates will go down.

Am I missing something here, money supply seems to move in opposite direction to interest rates in the last paragraph. However, in the second last statement, money supply went up with an increase in interest ratesjavascript:emoticon('

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T-Money · #2 11-29-2002, 07:01 PM

I believe that in this case government spending has increased and thus government saving has declined. This leads to a rightward shift in the IS curve and we will see higher interest rates and output. Private investment however will decline as a result a result of the increased government spending and increased interest rates (crowding out effect). So... r: up, Y: up, I: down. That was what I and my macro professor thought anyway.

WillPower · #3 11-29-2002, 07:46 PM

T-Money,
you seem to agree with me on the answer to the question that was on the exam. Your analysis is correct. What I need is clarification on why there seems to be a contradiction on the effect of interest rates on Money Supply as you read through my post

EconWiz · #4 11-29-2002, 08:44 PM

Quote:

Originally Posted by WillPower

What happens as a result of an increase in deficit (govt. spending) in terms of Investment, Interest rates and Output. I think the correct answer was output/income increases, so Interest rates go up, then Investments go down which means private savings go up blah blah

See, I really thought I understood this stuff because I also know or was told that an increase in interest rates will increase money supply.

I don't see how increased government spending (expansionary fiscal policy) affects the money supply.

In general, an increase in the money supply (expansionary monetary policy) results in a decrease in nominal interest rates as you described in your second example.

Avi · #5 12-01-2002, 02:04 PM

Quote:

Originally Posted by WillPower

For those of you who sat for C2 recently you will remember this question.

What happens as a result of an increase in deficit (govt. spending) in terms of Investment, Interest rates and Output. I think the correct answer was output/income increases, so Interest rates go up, then Investments go down which means private savings go up blah blah

See, I really thought I understood this stuff because I also know or was told that an increase in interest rates will increase money supply.

But then, a govt purchase of bonds "creates money from thin air", and therefore, increases the money supply. Govt buying bonds implies the price of bonds will go up which means interest rates will go down.

Am I missing something here, money supply seems to move in opposite direction to interest rates in the last paragraph. However, in the second last statement, money supply went up with an increase in interest ratesjavascript:emoticon('

')

If I recall correctly:

An increase in gov't spending increases output, as G is a component of Y. It also "crowds out" domestic investment, causing private business invstment to decrease. All things being equal, an increase in output will result in an outward movemnt of the IS curve, increasing interest rates. That's fiscal policy.

The gov't buying bonds is monetary policy, having nothing to do with real output. Also, an increase in interest rates will NOT increase the exogenous money supply; only the Fed can do that by buying bonds, lowering the reserve requirement, or lowering the Federal Funds rate. When interest rates go up due to an increase in output, the demand for money will drop and more people will keep their money in sevurities or banks as opposed to capital investments.

When the Fed buys bonds, however, if I understand it correctly, what they do is pump case into the marketplace in exchange for those pieces of paper we call "bonds". As such, there is a net increase of money supply. What is the price one pays for money? It's the interest rate. SO if there is a glut of supply, then the price goes down, so interest rates fall.

So if the gov't wants to increase spending and yet not have interest rates rise, they would simultaneously increase the money supply.

They would also do this to prevent inflation: MV = PY so if you increase M as you increase Y, P would remain constant.

However, unless I've forgotten, merely raising interest rates can not affect money supply, only money demand.