money supply, interest rates and inflation holding, interest, someone, decrease, getting

TheMBAGlover

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??

smartpants

chetan86 Wrote:
-------------------------------------------------------
> 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.

Mechanic

Equilibrium Interest Rate is when Supply (Vertical) and Demand (Horizontal) intersect.

1) If you have more money than you need, you are above the equilibrium point (demand is less than supply area). With the excess money, you buy bonds. Injecting your case into the banks circulation allows for more loanable funds. This increase, decreases the interest -- pushes the rate downward towards equilibrium.

2) If you have less funds that you need, demand is greater than supply, you sell your bonds to get your cash. By selling bonds, you reduce the loanable money (thats in circulation) which increases the rates -- pushes the rate upward to equilibrium.

I am visual, so I picture this on a graph. Downward sloping demand, and vertical supply. Anything in the top left corner (excess personal funds, and you need to get down to equilibrium) and vice versa.

Also note, than when rates are low, you usually borrow money (opp cost is low), and that decreases supply pushing rates up.

When rates are high, opportunity cost for holding money is high, therefore you buy - increasing supply, pushing rates down.