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Money and Interest Rates.docx

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Zisimos Koustas

Money and Interest Rates The liquidity preference analysis seems to lead to the conclusion that can increase in the money supply will lead to lower interest rates Nobel laureate Milton Friedman has raised an important criticism of this conclusion. Friedman acknowledges the validity of the liquidity effect other things equal, or ceteris paribus however, he challenges the ceteris paribus assumption in this case. An increase in the money supply may not leave other things equal and may in fact lead to higher interest rates. The following may change as a result of an increase in the money supply: M^s↑ Y↑ M^d↑ i↑ M^s↑ P ↑ M^d↑ i↑ M^s↑ P ↑ ∏^e↑ i↑ B^d↓ B^d – B^s <0 Bond prices↓ i↑ Does a higher rate of growth of the money supply cause lower interest rates? The answer is probably yes in the short run, but probably not over the medium and long run. To understand this, note that the liquidity effect occurs immediately and lower i in the short run. Over time, the income price level, and expected inflation effects raise i, the net effect depends on the relative strength of these factors. The following graph illustrates this argument: Interest rate i (a) liquidity effect larger than Other effects i1 i2 time Liquidity Time income effect price level & expected Interest rate i inflation effects (b) Liquidity effect larger than other effects & adjustment or expected i2 inflation i1 time Liquidity effect Income price level & expected inflation effects Interest rate i (c) liquidity effect smaller than expected inflation & fast adjustment i2 of expected inflation i1 time Liquidity expected inflation Income & price level effect effects The graph supports the above conclusion; namely, higher monetary growth levels to higher i in
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