It is impossible to target both the money supply and the rate of interest. If you control one you have to let the other be as it will. Discuss

The model below illustrates demand for money (L) and the effects on interest rates (I) when supply of money (M) changes.

Market rate of interest at its equilibrium (I) lies where total demand of money (L) is equal to supply of money (M). This is known as the liquidity-preference theory of interest and originates from the Keynesian theory. If the interest rate was greater than at point (I) there would be an excess of supply of money. This would push interest rates back down towards equilibrium. Similarly if interest rates were below (I1) excess demand for money would push interest rates back up.

To review a change in money supply (Ms) we find that if it is increased to point Ms2 an excess supply of money at the interest rate I1 occurs. Eventually though the rate of interest will reach I2. The line from I1 to Ms and I2 to Ms2 has been identified by Keynes as the liquidity trap. This is where demand for money becomes perfectly interest-elastic at a very low interest rate. It is thought that at such uncommonly low interest rates there is the expectation that they will eventually return to a normal level. Therefore everyone would also expect a fall in the price of bonds leading to capital losses for those who hold bonds. If the monetary authorities increase money supply, this increase would be added to speculative balances leaving the interest rate unchanged. This is illustrated in the previously model by a shift in supply of money from Ms2 to Ms3. Despite this shift to the right, the rate of interest remains at I2. In the above case the monetary policy is unable to push interest rates down or have any effect on consumption or investment. This enforces the argument that both money supply and the rate of interest cannot be controlled together.

However it can be argued that there has been no conclusive evidence to support the Keynesian liquidity trap theory. Even if it does exist the restriction to money and bonds somewhat limits the theory. The monetarist model takes a different approach. Both models agree that peoples attempt to spend their excess money balances on bonds. However Monetarists believe money is also spent on physical goods. Although both affect interest rates by pushing them down, money spent on physical goods also pushes up the output of goods and services. We can view the change in the model below.

With the increase in money supply being illustrated by the shift from Ms to Ms2. If we include the demand for money curve we see that interest rates falls from I to I2.

To follow the monetary view, an increase In output results in the nominal demand for money increasing at every interest rate and therefore up to MD1. This leads to the interest rate shifting to I3 and also to a higher level of national income.

The transmission mechanism identifies how the change of one economic variable will affect other variables. There are again two different opinions towards transmission mechanism, the Keynesian and monetarist theory. We will consider both with regard to how an increase in the money supply can affect the rate of interest and national income. According to Keynes’ mechanism spending is affected indirectly with regard to a change in money supply. An increase in money supply reduces the cost of borrowing as it provokes a fall in interest rates. Investment spending therefore may rise as the rate lowers. (That is if we do not consider investment to be interest-inelastic.) A lowered investment rate may also entail a lower mortgage rate. The demand for home loans would therefore increase with people taking advantage of such low borrowing rates. This may also increase consumer spending as people will have more disposal income. If the increase in money supply reduces the rate of interest there will be an outflow of short-term capital that will aim for higher rates of returns overseas. The effects of this will depend on whether there is a fixed or flexible exchange rate. A fixed exchange rate is one controlled by the Government where the value of one currency is constant with other currencies. The outflow of short-term capital leads to a fall in money supply thus retracting the initial increase. Using a flexible exchange rate will lead to an increased demand in exports and fall in demand of imports due to depreciation of domestic currency and a lower domestic interest rate.

The monetarist transmission mechanism features both direct and indirect of an increase in money supply. It believes that an increase in money supply will lead to firms and households spending extra money on goods and services. This is direct transmission mechanism. The lowering of interest rates, which has an indirect affect on spending is therefore known as indirect transmission mechanism. Monetarists however believe investment and consumption to be more interest elastic than Keynesians. They argue that supply of money is mostly independent of interest rates.

Interest rates are set by the Central bank at a rate they find appropriate. As a result of this the bank can force their desired increase in interest rates in the markets. Therefore all other short-term interest rates in the money market are lead by this rate. As a result of this there occurs a rise in the cost of borrowing that, in many circumstances, decreases the demand for loanable funds. This will therefore slow down the growth in supply of money. If Central bank wishes to increase the stock of money within the economy it can buy securities on the open market. This would lead to a fall in interest rates and a rise in the demand for loanable funds resulting in an increase in the money supply.

Overall I believe that if money supply is raised the rate of interest can be reduced in order to restore equilibrium. Therefore both can be controlled. The difficulty lies in attempting to control both if Government wish to reduce the supply of money. This will lead to higher interest rates and a rise in demand for money as people want their assets in liquid form. Therefore Government will have to increase the supply of money. However if the economy is in a recession, no matter how low interest rates are driven, people cannot be forced to borrow. If a continuing recession is predicted firms will not borrow to invest. Therefore supply of money and rate of interest cannot be targeted at the same time.