Money Supply, Interest Rates, and the Yield Curve

Abstract

THE EFFECT OF MONEY on interest rates is a subject that has a long and controversial history in economics. The mercantilistsl believed an increase in the supply of money would result in a fall in the rate of interest. It was argued that since interest is the rental price of money, the more money there is the lower this rental price must be. Others, David Hume [6] for example, disagreed with the mercantilists' purely monetary theory of the rate of interest. Hume pointed out that an increase in the supply of money would result in a proportionate increase in the price level and as a result there would be no increase in the real money supply and no fall in the interest rate. However, he argued that the price level would not adjust instantaneously to changes in the money supply and in the intermediate situation between the increase in the money supply and the increase in the price level the interest rate could fall (but this fall would only be temporary). More recently, John Maynard Keynes [7] argued that an increase in the supply of money would result in a fall in the interest rate (unless the IS curve was horizontal). Although Keynes' theory has strong similarities to the mercantilists' theory, Keynes qualified his theory by assuming the price level was fixed. As such, his effect of money on interest rates can be interpreted as a short-run effect (similar to the effect of money on interest in Hume's 'intermediate situation'). The above theories implicitly assume that if the price level changes it would be a once and for all change, i.e., the expected rate of inflation is zero. In such models there is no need to distinguish between real and nominal rates of interest. However,