Chapter 13 · Demand-side and supply-side policies
Changes in the supply of money
Compare increases and decreases in the money supply. Use a money-market diagram to explain the change in the equilibrium interest rate.
The economic idea
Monetary policy is central-bank action intended to influence aggregate demand and achieve objectives such as price stability and sustainable economic activity. Expansionary monetary policy eases financial conditions; contractionary monetary policy tightens them.
In the simplified quantity-of-money model, an open-market purchase injects central-bank money and shifts money supply right, while an open-market sale withdraws it and shifts supply left. The resulting portfolio imbalance changes bond prices and market interest rates.
Lower interest rates can increase interest-sensitive consumption and investment, raise asset prices, weaken the exchange rate and support aggregate demand. Higher rates normally work in the opposite direction. The effect is neither immediate nor guaranteed because banks, borrowers and expectations mediate transmission.
Quantitative easing is the central-bank purchase of financial assets, usually used when the policy rate is near its lower bound. It aims to lower longer-term yields, improve liquidity and influence portfolio choices and expectations; it is not simply the printing of cash for government spending.
Central-bank reserves, the monetary base and broad money are distinct. Asset purchases reliably create reserves, but the response of bank deposits, lending and spending depends on balance sheets, credit demand, regulation and confidence.
Reading contraction through Sₘ₃ and expansion through Sₘ₂
“Rate of interest” is measured vertically and “Quantity of money” horizontally.
“Dₘ” is held constant. “Sₘ₁” is the initial money supply, “Sₘ₃” the lower supply and “Sₘ₂” the higher supply.
“i₃”, “i₁” and “i₂” label the equilibrium interest rates where each supply curve intersects “Dₘ”.
Initial position: Sₘ₁ and i₁
“Sₘ₁” intersects “Dₘ” at the initial equilibrium rate “i₁”. This is the benchmark for both policy comparisons.
Contraction: Sₘ₁ to Sₘ₃
At the old rate “i₁”, the lower money supply creates excess demand for money. Bond sales reduce bond prices and raise the rate until “Sₘ₃” intersects “Dₘ” at “i₃”.
Expansion: Sₘ₁ to Sₘ₂
At the old rate “i₁”, the higher money supply creates excess money balances. Bond purchases raise bond prices and lower the rate until “Sₘ₂” intersects “Dₘ” at “i₂”.
The interest-rate change is one link in a longer chain
In the textbook model, an increase in money supply can leave people holding more money than they want at the original interest rate. Purchases of bonds raise bond prices and lower their yields, helping explain the fall in the interest rate.
To explain a monetary-policy effect on real output, continue the chain through consumption or investment and then AD. This diagram does not show that later response, and weak confidence or limited willingness to borrow may reduce it. Many central banks implement policy by targeting a short-term interest rate rather than fixing the quantity of money directly.
From central-bank operations to aggregate-demand transmission
The central bank changes liquidity, moving money supply away from “Sₘ₁” toward “Sₘ₃” or “Sₘ₂”.
Portfolio holders buy or sell bonds because actual money balances differ from desired balances at the initial rate.
“Sₘ₃” lies to the left of “Sₘ₁”, so a contraction in money supply raises the equilibrium interest rate from “i₁” to “i₃”. “Sₘ₂” lies to the right of “Sₘ₁”, so an expansion lowers the rate from “i₁” to “i₂”, holding “Dₘ” constant.
The changed market rate affects borrowing, debt service, consumption and investment, while asset-price, exchange-rate, credit and expectations channels may reinforce or weaken the effect on aggregate demand.
Common mistakes to avoid
- “Sₘ₃” and “Sₘ₂” are alternatives around “Sₘ₁”; the graph does not show the economy moving through both policies in sequence.
- A larger monetary base does not imply a mechanically proportional increase in broad money, bank lending or spending.
- A lower nominal interest rate is not necessarily a lower real interest rate if inflation expectations change.
- Quantitative easing works mainly through asset purchases and financial conditions, not direct central-bank purchases of ordinary goods and services.
- The money-market diagram does not by itself show the final size of the shift in aggregate demand, output or inflation.
How to draw this diagram
- Title the diagram “Changes in the supply of money”. Label the horizontal axis “Quantity of money” and the vertical axis “Rate of interest”.
- Draw Dₘ first and label it clearly.
- Draw Sₘ₃ next and label it clearly.
- Draw Sₘ₁ next and label it clearly.
- Draw Sₘ₂ next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The model treats money supply as exogenous and vertical, unlike operating systems centred on an interest-rate target.
- It combines base money, reserves and broader monetary aggregates even though their behaviour differs.
- One interest rate stands in for an entire term structure and multiple risk premia.
- Bank balance sheets, collateral, capital regulation and credit rationing are omitted.
- The graph ends at the money-market rate and does not quantify the later AD–AS response.