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Direct and Indirect Effect of Monetary Expansion on Interest Rates

Direct and Indirect effect of monetary expansion on interest rates.

We have seen the two ways that money supply increases caused by banks can affect interest rates –

The Direct Effect – Loans created by banks adds to the supply of money in the economy by creating an equivalent deposit. This causes the supply curve to shift right and interest rates to fall.

The Indirect Effect – Since monetary expansion may cause a rise in inflation, it would increase borrowers and lender’s expectations of inflation. This increase in inflation expectation causes an increase in the nominal interest rates.

We can see that these two effects work in the opposite direction. The net result depends on the following –

The increase in banking loans and other sources of funds adds to the total supply of funds. This is the direct effect of funds on interest rates and will lower interest rates all other factors remaining constant. Obviously any other factor that causes the demand curve to shift right will negate the impact of the supply curve shift and thereby the interest rate increase.

More than often a rapid monetary expansion immediately causes the expected inflation to rise, therefore the nominal interest rates to rise and the real rates to fall.

Since bank loans are relatively short term interest rates, the supply of short term loans increase. If we consider two separate markets for short term funds where the interest rates are short term rates (ie the short end of the yield curve) and longer term funds with long term rates (the long end of the yield curve) then the increase of banking loans and deposits has an impact on short term interest rates.

Longer term rates deals with long term expected inflation rates which is much harder to predict than short term inflation expectations. Therefore the indirect effect will have a greater impact on longer term rates. A rapid monetary expansion usually lowers short term interest rates since the direct effect on loans is to shift the money supply to the right. The indirect effect would raise longer term nominal interest rates since the inflation expectations would increase.

Its very important to understand this as we will see in later sessions when studying the effects of central banks monetary policy that the monetary policy impacts only short term rates.

We have seen the effects of monetary expansion and contraction on account of the banking system on interest rates directly and indirectly through inflation. Increase and decreases in inflation also affects the holding period yield since the HPY of a foreign asset is a function of interest rates and exchange rates. The interest rate is the nominal interest rate which in turn is equal to the real rate and an inflation premium. If inflation rates rise hence expected inflation rises the real rate of interest will fall and the real rate of return on the HPY also falls.

The question now is who controls this monetary expansion or contraction though banking loans and how do they control it? Its impact on macro economic factors such as interest rates, exchange rates, inflation rates that in turn affect the flows of funds from various other economic entities such as households, firms, governments and the ROW is too important a function to be left to individual banks.

In most countries controlling the banking system to create money is the job for the central bank. Central banks such as the Federal Reserve Bank, Bank of England, Bank of Japan, Reserve Bank of Australia and more control the expansion and contraction of money through monetary policy. How monetary policy is determined and implemented is a key component to trading financial markets. At the end of the day all eyes are on the Fed.

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