Chapter 1
Money supply

In the classical $M^S-i$-diagram in connection with the supply/demand diagram in the credit market, it is very easy to illustrate how monetary policy can influence the interest rate, or how monetary policy can be realized by means of the interest rate. It also shows other factors that determine the efficiency and limits of this mechanism. The graph on the left shows the real money supply of the central bank and the liquidity demand of the financial sector. The right graph shows supply and demand in the credit market. Monetary policy impulses from the central bank either can directly affect the credit market (for example, by influencing expected inflation, see Fisher-effect) or by lowering the refinancing interest rates of the banks, which then (partially) transfer them to the credit market.

The level of interest rates is determined by a sufficiently interest-elastic demand for financial resources as well as (in the simplest case) an exogenous supply. Four main effects can be identified:

1. Liquidity- or Keynes- effect
2. Price level- or Fisher- effect
3. Uncertainty- or Friedman- effect
4. Income- or Wicksell- effect

It describes the classical and central relationship between money stock (or money supply) and interest rates. If the money supply, i.e. the amount of liquidity provided by the central bank, increases c.p., then the price of this liquidity decreases. This price is the key interest rate. The graph on the left shows this link of the liquidity demand curve (i.e. the demand curve for financial resources) and the real money supply. The demand for liquidity is interest-elastic, i.e. if the interest rate is lower, more liquidity is demanded (because the cost of holding liquid funds is low). Hence, the demand curve falls. Money supply is exogenous, i.e. it is fixed by the central bank and is independent of the interest rate. Therefore, the supply curve runs vertical. Using the slider, the central bank’s money supply can be changed. The money supply (point GA) shifts and the interest rate rises or falls, accordingly. The same applies to a change in the current price level. If the current price level rises and the nominal money supply $M^S$ remains the same, then the real money supply $\frac{M^S}{P}$ decreases. Consequently, the key interest rate increases if the central bank does not change the nominal money supply when the current price level rises. The difference to the increase in the expected future price level (= expected inflation) within the framework of the Fisher-Effect is thus in the chain of effects, not in the result.

If the key interest rate falls (rises), the refinancing of credit institutions becomes more expensive and the supply of credit on the credit market (right graph) shifts downwards (upwards).

Irving Fisher postulated the effect named after him as early as 1896. In his theory, Fisher clearly distinguishes between the real and the monetary domain of economy (classical dichotomy). The real interest rate constitutes the balance between the demand for capital goods and savings without monetary influences. The nominal interest rate is calculated as the real interest rate plus a compensation for the expected loss of purchasing power of the loan amount. The lender tries to protect himself against the loss of purchasing power by demanding a higher interest rate. On the other hand, the borrower is prepared to pay a higher interest rate because he/she generates income by investing the funds in real assets which are nominally revalued by the price increases.

$$i\sim {\pi }^e+r$$

Thus, the nominal interest rate increases one-to-one with the expected inflation rate. The expected inflation rate, in turn, depends on past price increases and expected monetary policy measures, while the real interest rate is not (cannot be) changed by monetary policy. If the expected inflation rate increases by a certain percentage, the nominal interest rate is expected to increase by the same percentage.

A change in expected inflation shows in an up or down shift of credit supply and demand by exactly this amount.

Friedman argues that risk-averse investors demand a premium for the uncertainty associated with monetary policy measures. Because of the risk of inflation, the greater the uncertainty the higher becomes the risk premium for holding cash, i.e. the nominal interest rate. An increase in uncertainty due to increased discretionary action by the central bank implies a negative influence on the supply of credit in the right-hand chart. Friedman suggests applying a rule to monetary policy to reduce uncertainty. The stricter the rule, the lower the uncertainty and the lower the interest rate. Friedman’s k% rule, according to which the money supply should grow by k% annually, is most likely the rule with the least uncertainty. However, such rules are very inflexible and deprive monetary policy of the opportunity to reduce welfare losses and intervene in crises through discretionary decisions.

The Income or Wicksell-Effect differs from the other three effects of monetary policy on the financial market primarily because it analyzes the direct implications of an event at the financial market (change in interest rates) on the real economy. Therefore, it cannot be shown directly in a graph.

Wicksell was the first to distinguish between "normal" (=nominal) and "natural" (=real) interest rates. The natural interest rate corresponds to the marginal efficiency of capital, i.e. the rate of return that a new investment yields. If the interest rate (price of credit) falls (for example as a result of monetary policy measures by the central bank), then the current marginal efficiency of capital (= return on a new investment) exceeds its cost (= interest). As a result, companies will take up more loans from banks in order to make more investments. Due to the decreasing marginal utility of investment opportunities (good investments are made first), this leads to decreasing returns. This process ends when the natural interest rate (= the return on an investment) has adjusted again to the market interest rate. This consideration assumes an exclusively or predominantly interest-oriented investment decision, although empirical evidence has not yet been provided for this assumption.

In the original Wicksell definition, the natural interest rate on capital is “the rate of interest on a loan at which it behaves neutral regarding the prices of goods and has no tendency to increase or decrease them”. Thus, he first points at the inflationary effects of monetary policy decisions and only later in his analysis does he refer to the equivalence to the return on capital.