Effects of Money on Interest Rates

Abstract

Monetary authorities also tend to take for granted that an increase in the money stock lowers interest rates. From their vantage point, an increase in the money stock by way of an open-market purchase tends to lower market rates quickly, since purchasing securities raises their prices and lowers yields. Indeed, they rely on this relation in order to control rates. Accordingly, interest-rate movements are frequently viewed as indicators of recent monetary policy. Since the money/interest-rate relation is used in implementing monetary policy, it is particularly important that the monetary authorities know how the relation works. If the monetary authorities believed that they lower interest rates by increasing the money stock whereas this at first lowers and then later raises rates, the authorities' actions would work first toward and then against an interest-rate goal. Further, if interest rates are viewed as indicators of monetary policy, incorrect conclusions can easily follow if total effects are disregarded in favor of initial effects. The trouble with using interest rates as indicators of monetary policy is as follows: If income increases faster than money, interest rates will tend to rise, but if the income increase results from increases in the money stock, should monetary policy be called restrictive?