Question

Explain why an increase in the money supply can affect interest rates in different ways. When answering this question, describe the potential impact of the supply and demand for loanable funds.

Answer 1

Interest rate is majorly dependent on the demand and supply of money. When people have ececess funds they invest it or deposit it which enables them to earn interest on that amount. Similarly, when people are in short of funds, they borrow funds and they have to pay interest on the amount borrowed. Interest rate is a function of demand and supply. If there is an increase in money supply,it means there is a lot of money in the economy, with lot of money people will deposit more and borrow less. Now lending institutions will be able to charge lower interest on loans because the demand of loans is less. Similarly lower interest will be paid on deposits since the supply is more and demand is less.