<p>Because if you hold demand constant and increase supply of anything, money included, only way how you can clear the market is to decrease price. We assume that at the original price market did clear. Consequently, the customers would not be willing to purchase higher quantity without lowering the price (unless the demand is perfectly inelastic or elastic). In money market interest is the price of money.</p>

CC BY-SA 4.0
2022-11-13T23:41:48.313Z
2022-11-14T00:28:37.213Z
2022-11-14T00:28:37.213Z
csilvia
<p>I'm currently working through the textbook Macroeconomics: European Perspective. I'm on chapter 4: financial markets. I'm struggling with the intuition for why increases in the central bank money supply decreases the interest rate.</p>
<p>If we set the model up as:</p>
<p><span class="math-container">$M^d = £Y\times L(i)$</span>, where <span class="math-container">$M^d$</span> is the model demanded, <span class="math-container">$£Y$</span> is the nominal income level, and <span class="math-container">$L(i)$</span> is the function of interest rates (which decreases as they rise) that relates the two.</p>
<p>Then at equilibrium, we know that the money supply, <span class="math-container">$M^s$</span>, must equal the money demanded <span class="math-container">$M^d$</span>, which gives us:</p>
<p><span class="math-container">$M^s= £Y\times L(i)$</span></p>
<p>On this basis if we hold the level of nominal income fixed <span class="math-container">$£Y$</span>, then an increase in the money supply <span class="math-container">$M^s$</span>, will increase <span class="math-container">$L(i)$</span>, which is achieved through decreasing the interest rate <span class="math-container">$i$</span>.</p>
<p>That's all straightforward as it goes.</p>
<p>However, I struggle to understand the intuition for this. If we had a simplified situation where consumers and banks can either hold currency or bonds, then I understand that increasing the interest rate increases the incentive to hold bonds and therefore decreases the demand for the supply of currency. The opposite obviously follows with decreasing interest rates.</p>
<p>I also follow that if we increase nominal income, then we increase the demand for transactions and therefore currency. To keep demand for currency at the level before nominal income increased, an increase in the interest rate is needed.</p>
<p>But if we are at equilibrium and we increase the money supply, I don't get a feel for why the interest rate must fall?</p>
<p>Thanks for any help,</p>
<p>Hmmm16</p>

CC BY-SA 4.0
2022-11-13T21:23:52.277Z
Ok, so I think this may actually be even more obvious than I expected. If we are at equilibrium and we increase the money supply, then to get back to the new equilibrium we need to 'incentivise' the demand for more money so that $M^s = M^d$. We do that by decreasing the interest rate which makes holding bonds vs currency less attractive.
hmmmm
CC BY-SA 4.0
2024-08-05T06:03:10.510Z
Maybe a simple way to think about is that when you increase the money supply you increase prices - in this case bond price - if the price of bonds goes up that means the same future cash flow has become more expensive to acquire which is tantamount to a lower rent. I by no means claim this is what happens - I just vaguely recall that is how my teacher tried to make it intuitively appealing.
Jesper Hybel
<macroeconomics>
Intuition for money supply and interest rates
hmmmm
# Intuition for money supply and interest rates

(Asked by: username_0 on 2022-11-13)

I'm currently working through the textbook Macroeconomics: European Perspective. I'm on chapter 4: financial markets. I'm struggling with the intuition for why increases in the central bank money supply decreases the interest rate.

If we set the model up as:

$M^d = £Y\times L(i)$, where $M^d$ is the model demanded, $£Y$ is the nominal income level, and $L(i)$ is the function of interest rates (which decreases as they rise) that relates the two.

Then at equilibrium, we know that the money supply, $M^s$, must equal the money demanded $M^d$, which gives us:

$M^s= £Y\times L(i)$

On this basis if we hold the level of nominal income fixed $£Y$, then an increase in the money supply $M^s$, will increase $L(i)$, which is achieved through decreasing the interest rate $i$.

That's all straightforward as it goes.

However, I struggle to understand the intuition for this. If we had a simplified situation where consumers and banks can either hold currency or bonds, then I understand that increasing the interest rate increases the incentive to hold bonds and therefore decreases the demand for the supply of currency. The opposite obviously follows with decreasing interest rates.

I also follow that if we increase nominal income, then we increase the demand for transactions and therefore currency. To keep demand for currency at the level before nominal income increased, an increase in the interest rate is needed.

But if we are at equilibrium and we increase the money supply, I don't get a feel for why the interest rate must fall?

Thanks for any help,

Hmmm16

**Tags:** macroeconomics

> **Comments:**
> **username_0**: Ok, so I think this may actually be even more obvious than I expected. If we are at equilibrium and we increase the money supply, then to get back to the new equilibrium we need to 'incentivise' the demand for more money so that $M^s = M^d$. We do that by decreasing the interest rate which makes holding bonds vs currency less attractive.  
> **username_1**: Maybe a simple way to think about is that when you increase the money supply you increase prices - in this case bond price - if the price of bonds goes up that means the same future cash flow has become more expensive to acquire which is tantamount to a lower rent. I by no means claim this is what happens - I just vaguely recall that is how my teacher tried to make it intuitively appealing.  

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## 1 answers

### Answer by username_2 on 2022-11-13. Score: -1

Because if you hold demand constant and increase supply of anything, money included, only way how you can clear the market is to decrease price. We assume that at the original price market did clear. Consequently, the customers would not be willing to purchase higher quantity without lowering the price (unless the demand is perfectly inelastic or elastic). In money market interest is the price of money.


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