Increase In Real Money Supply
Reduction In Real Money Supply

A Reduction in the Money Supply. Now that we have seen how the interest rate is determined, we can use the theory of liquidity preference to show how the interest rate responds to changes in the supply of money. Suppose, for instance, that the Fed suddenly decreases the money supply. The supply of real money balances shifts to the left. Answers to Questions from Chapter 14 (1) A reduction in real money demand has the same effects as an increase in the nominal money supply. In Figure 14.1, the reduction in money demand is depicted as a backward shift in the money demand schedule from L1 to L2.

The relationship between money supply and price level lies in the fact that the amount of money in circulation in an economy has a direct impact on the aggregate price level. This is mainly because an abundance of money leads to an increase in demand for goods and services, while a scarcity of money has the opposite effect. In economic terms, this effect is explained by the quantity theory of money, which states that the amount of money in supply in an economy has a direct bearing on the price level.

A simple way of looking at the relationship between money supply and price level is to consider the fact that consumers will only spend when they have something to spend. That is to say that when there is a lot of money in the economy, people will have more to spend. This increase in demand also causes a corresponding increase in the price level. Excess liquidity leads to a situation in which a lot of cash will be vying for an often limited supply of goods. This causes the money to gradually lose its value, which consequently leads to price increases.

Increase In Real Money Supply

Economists rely on the relationship between money supply and price level as one of the indicators of the state of the economy. When there is a rise in the aggregate price, one of the chief factors responsible is too much demand caused by consumers having easy access to money. The response of the government to this is often to introduce monetary or fiscal policies meant to restrict the ease with which consumers can obtain money, including bank loans and various types of credit. One method by which the government can restrict access to money is through increases in general interest rates.

Reduction In Real Money Supply

The effect of this restriction further illustrates the relationship between money supply and price level, because this maneuver usually forces the price level to drop. When the central bank of a country increases the interest rate, consumers may find the conditions attached to obtaining money to be either too prohibitively expensive or too rigorous, as other banks tighten their lending policies in response to the interest rates increase. As a consequence of the lack of easy access to funds, consumers tend to become more conservative in their spending habits, leading to a drop in the demand for goods and services. The consequence of a reduction in demand is an accompanying drop in the prices of goods and services.