smartpants

chetan86 Wrote:
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> Could someone explain the linkage between money
> supply interest rates and inflation? I keep
> getting confused.
>
> Take this Q for example:
>
> Households hold more real money than they desire
> which is least likely to happen?
>
> 1)The interest rate is higher than its equilibrium
> rate in the market for real money balances
> 2)The central bank must sell securities to absorb
> the excess money supply and establish
> equilibrium.
> 3)The opportunity cost of holding money balances
> will decrease.
>
> The answer is 2), but the comments along with the
> answer baffled me!
> "If households’ real money balances are larger
> than they desire, the interest rate (opportunity
> cost of holding money balances) is higher than its
> equilibrium rate. Households will use their
> undesired excess cash to buy securities, bidding
> up securities prices and reducing the interest
> rate toward equilibrium. This market process does
> not require any action by the central bank."
>
> If households buy securities, i.e. Treasury sells
> and so reduce money supply - does decrease of
> money supply not lead to a reduction in inflation
> and therefore an increase in interest rate??


I think the question and answer are terribly worded. Question says "what is least likely to happen?"
Option (A) says "IR IS higher"
Option (C) says "IR will go down"
Both of these are true but option (A) is illogical if you look at it from the question perspective. Also, they will happen in different time frames. They contradict each other which is confusing.

Anyway, from what I understand, the logic is this. When households hold more money, the supply of money decreases and hence short term IR goes up. Eventually, the households will use this excess money and buy securities, pumping the money back into the system. The supply of money will increase and IR will go down.