Basic questions – money suppy and interest rates

This was originally posted in our forum and reposted here when the forum closed.

Q. I was wondering if I could have some help understanding some basics.

When a government increases the money supply, where does this money go immediately? I mean, when it increases money supply, who exactly gets this extra money, and how?

Also, I think that when there is more money, inflation rises. But how are interest rates affected? And why?

Finally, I know what deflation is, but I don’t understand what can cause it and the negative implications it has. Can someone explain it, in simple language please? I would be most grateful.

A. Usually the central bank hangs on to that money and slowly send it out as demand warrants. (That means the bigger banks borrow the money from the central bank.)

Inflation goes up dependent on consumer spending and behaviour, etc. Interest rates may increase in order to reduce spending. The central bank will make that decision to increase or decrease interest rates based on a bunch of data.

Deflation could theoretically occur (it does if you mean by deflation negative inflation). For example, the US finds a billion barrels of oil in Texas and prices decrease by 50%. That would lead to a drop in inflation.

One comment

  1. When the central bank, in our case, the federal reserve, determines that it would be appropriate to increse money supply, it has two mechanisms to do so. First, and the most known, is that it can reduce the “fed funds rate,” commonly explained as the rate of interest banks charge other banks to borrow money. Lowering the interest rate reduces the cost of funds, which typically reduces the risk premium that must be charged to the end user, the borrower. In short, when money is cheap, banks are more willing to lend, and often more willing to lend to higher risk borrowers. It’s the basic concept of supply and demand. When costs are lower, the potential returns to banks are higher, making them more willing to lend, and hense “expanding money supply.”

    The other, less talked about way that the fed can increase money supply is through “open market activities.” Specifically, the buying and selling of US treasury notes (T-Bills). If the fed wants to increase money supply, they will purchase treasury notes on the open market, this takes T-bills out of the open market and directly injects cash. When it wishes to reduce money supply, it purchases T-bills taking cash out of the market and puting it back into reserves.

    Interest rates are either directly effected by the actions of the fed (reducing the fed funds rate) or indirectly effected by, again, basic supply and demand. In the latter case, direct injections of money into the economy via open market activities increases the supply of cash, and can lower interest rates if supply outpaces demand. Interest rates are, after all, nothing more than the “price of money,” and if everybody has it to lend, it’s worth less.

    With respect to deflation, while external factors such as that noted in the initial response to your question could have deflationary effects on specific commodities, as a macroeconomic concern deflation generally occurs in the form of a lowering of general prices (The CPI) as a response to reduced demand. If retailers cannot market their goods at current market prices, they will reduce those prices as an incentive to induce sales (Like when your local Best Buy marks everything down 50% for a “going out of business” sale). This causes competitors to reduce prices and so on and so on, until prices on a macro level begin to show declines. The bigger concern is that negative price preasures will flow back up the value chain and eventually lead to reduced production, job loss, and a self feeding cycle.

    As my title indicates, I’m no expert, but that’s my understanding of it all.

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