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Money Supply, Inflation, Interest Rates and Exchange Rates

Effect of Monetary Expansion and Contraction on Inflation and Exchange rates

We have seen through shifts in the demand and supply curve how monetary expansion and contraction affects interest rates and exchange rates. Monetary expansion and contraction also affects interest rates and exchange rates indirectly by influencing prices.

Monetary expansion increases spending. Borrowers such as households spend money on consumption expenditures, firms spend on investments, governments on infrastructure and so on. As we have seen in the economic indicators course an increase in expenditures causes an increase in economic growth. This increase in expenditure increases the demand for goods and services produced in an economy. An increase in demand causes increase in the production of goods and services. As production increases the demand for factors of production such as raw materials increase causing costs to rise. Firms now pass on these rising cost to consumers in the form of higher prices. Higher prices translates to higher inflation.

Monetary contraction works in exactly the opposite manner. When money is tight in the economy, when loans are closing faster than ones being created spending decreases. This reduction in expenditure by households, firms, governments causes the demand for goods and services to reduce. This in turn causes production by firms to slow down, slowing down the demand for factors of production such as labor, raw materials etc. Firms now need to lower prices to induce demand for their goods and services. A lowering of prices causes a lowering of inflation.

The faster monetary expansion the faster the rise in prices and higher the inflation. The velocity of monetary expansion is important to keep an eye on.

So far the interest rates that we have been  discussing have been nominal interest rates. Nominal interest rates are the rates we see in our daily lives. The price of money. Interest rates on mortgages, bonds, T-bills, loans etc are all expressed in nominal terms. However the real interest rate that is payed or earned from a security is highly dependent on the inflation premium. The nominal interest rate is a function of the real interest rate plus the inflation premium.

As an approximation

Nominal Interest Rate = Real Interest Rate + Inflation Rate

or Real Interest Rate = Nominal Interest Rate – Inflation Rate

In an economy where prices are rising and therefore inflation is rising the higher the inflation rate the lower the real rate of interest that the lender will earn from an asset. In our demand and supply scenario the equilibrium interest rate accounts for the inflation rate. If the equilibrium rate is say 10% and the inflation rate is 4% then the real interest rate is 6%. Lenders can expect to earn 6% after accounting for a loss in purchasing power due to inflation. If the inflation rate rises further to 6% lenders are now looking at a return of 4% after accounting for the loss in purchasing power.

The above equation assumes a given interest rate over the life of the asset. Since no one can predict the inflation rate over the life of the asset they will need to deal with expectations. Therefore

expected real interest rate = nominal interest rate – expected inflation rate

When borrowers and lenders enter into contracts it is the expected real interest rate that they are concerned with. For example a nominal rate of 15% sounds great for lenders but if the expected inflation rate is 20% then lending makes no sense. This is because when the lender receives the loan repayment even though the dollar value of the loan repayment plus interest is high the real value of the repayment plus interest will be much lower yielding a negative yield.

Lets see how the expected inflation rate affects the funds market and the exchange rate markets.

Lets assume interest rates ie nominal interest rate to be 7%. Lets assume borrowers and lenders are factoring in an expected inflation rate of 3%. The total borrowing is equal to the total lending at say $100 billion. The equilibrium real interest rate is therefore approximately equal to 7%-3% = 4%.

Lets say due to strong economic growth income levels rise, consumption spending increases, CPI increases and the expected inflation rises from 3% to 4%. At a 7% nominal rate the advantage now tilts in favour of the borrower as the real interest rate drops to 7%-4% = 3%. Borrowers will therefore be willing to borrow more causing the demand curve to shift right. On the other hand lenders are now willing to lend less at the current nominal rate of 7% causing a shift in the supply curve to the left. This shift in supply and demand curve cause the interest rates to rise by 1% to 8%, by the same level as the rise in expected inflation rates. The total lending and borrowing remains the same at $100 billion since the real interest rate remains the same at 8%-4% = 4%.

This is a highly simplified example designed to illustrate the indirect effect of money supply on interest rates. In reality expectation of inflation are not easy to predict. Volatility of inflation rates is also an important consideration. Market participants prefer investing in economies with stable inflation rates.

Next - Direct and Indirect effect of Monetary Expansion on Interest Rates

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