Four Effects of Money Growth on Interest Rates
Faster money growth does not simply lower interest rates. The immediate liquidity effect pushes rates down, but three slower forces push them up: the income effect (a stronger economy lifts money demand and bond supply), the price-level effect (a higher price level raises money demand), and the expected-inflation effect (the Fisher effect on the nominal rate). Over time the upward forces can dominate, so faster money growth can raise nominal rates.
Why it matters
The first thing extra money does is make funds plentiful, which eases rates. After that the economy heats up, prices rise, and people expect more inflation, and each of those lifts rates back up. Whether rates end higher or lower depends on which effect wins and how fast inflation expectations adjust.
Worked examples
The United States ran persistently high money growth through the 1970s. What happened to nominal interest rates, and why does that fit this framework?
Nominal rates rose to high levels rather than falling. Sustained money growth fed high and rising expected inflation, so the expected-inflation effect overwhelmed the initial liquidity effect and the Fisher effect dragged nominal rates up.
A one-off increase in money growth happens where expected inflation barely moves. What is the likely path of the rate?
The liquidity effect can dominate, so the rate falls and stays lower. With little change in expected inflation, the income and price-level effects are mild and the upward forces never overtake the initial easing.
Common mistakes
- ✗More money growth always lowers interest rates. Only the immediate liquidity effect does that, and the income, price-level, and expected-inflation effects can push rates higher over time.
- ✗This is just the quantity theory restated. The quantity theory links money to nominal spending and prices, while this framework is specifically about the competing forces on the interest rate, including the timing of the liquidity effect against expected inflation.
- ✗The expected-inflation effect is the same as the Fisher equation alone. The Fisher relationship is just one of the four effects here, set against the liquidity, income, and price-level effects, not the whole story.
Revision bullets
- •Liquidity effect lowers rates immediately
- •Income, price-level, and expected-inflation effects raise them over time
- •Sustained money growth can raise nominal rates, as in the 1970s
Quick check
Which effect explains how faster money growth can eventually raise nominal interest rates?
Connected topics
Sources
- Mishkin (2018), Ch. 5Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The liquidity, income, price-level, and expected-inflation effects of money growth on interest rates.