College Preparatory Program • Saudi Aramco
Effect of Changes in Money Supply on Aggregate Demand
Microeconomic Tips
How Do Changes in the Money Supply Affect Aggregate Demand?
Key Point:
The FEDERAL RESERVE can control money supply in the market place by either
lowering or increasing the DISCOUNT RATE (interest rate charge for borrowing
between banks), and RESERVE RATIO (the percentage of its deposits a bank is allowed
to loan out).
(Important terms are in BOLD FONT. Search the Internet or your textbooks for their meaning.)
Hint:
An increase in Money Supply leads to lower interest rates.
 Consumers will want to invest more of their money rather than hold it.
 With lower interest rates THE OPPORTUNITY COST* for holding money is less.
For Example: Assume that the going interest rate is 3% and you have $5,000 in your
possession. The OPPORTUNITY COST* of holding that money would be 3% of
that amount, or $150. Ceretis Paribus, in this scenario it may make more
economic sense to hold the money in cash, checking account or travelers checks
(money in this form can be easily LIQUIDATED**) rather than leave it in an
interest bearing account for an entire year. Conversely, if that interest rate
rises to 5%, the opportunity cost of holding the money would be increase to
$250, and so on. We can say that the lower the interest rates the more induced
households and businesses may be to invest. Households may purchase more
durable items such as washing machines, cars—even buy a new home.
In turn, businesses may choose to invest in new equipment and technology.
(With lower interest rates the cost for borrowing money also drops.)
*The interest given up is the OPPORTUNITY COST of holding money.
**LIQUIDATED refers to how easily money can be utilized.
With cash, checking accounts, and money orders
money can be immediately used as a MEDIUM OF EXCHANGE.
However, bonds and other financial assets first have to be sold
(made liquid)—taking more time.
College Preparatory Program • Saudi Aramco
Effect of Changes in Money Supply on Aggregate Demand
INTEREST RATE and the SUPPLY of MONEY ARE INVERSELY RELATED
Graph A
Interest Rate
(Demand for Money)
Supply of Money
SUPPLY and DEMAND for MONEY
Key Point:
An increase in the Money Supply (MS1 to MS2) causes the Interest Rate to fall.
Interest rates fall from i1 to i2 and the Equilibrium Point drops from A to B showing an
increase in the Demand for Money. (See Graph B)
Graph B
Interest Rate
i₁
(Follow the arrows in the explanation)
A
i₂
B
(Demand for Money)
MS₁
Note:
MS₂
Supply of Money
In the event of a decrease in the Money Supply
reserve requirements), interest rates would increase
(Feds increase discount rate and raise
and demand for money decreases
.
College Preparatory Program • Saudi Aramco
Key Point:
Effect of Changes in Money Supply on Aggregate Demand
With interest rates falling DEMAND FOR INVESTMENT increases. Businesses may want
to take advantage of the REDUCTION IN OPPORTUNITY COSTS by investing in new
machines and plants. Households may decide to invest in real estate. (See Graph C)
DEMAND FOR INVESTMENT (HOUSEHOLD)
Graph C
Interest Rates
(Follow the arrows)
i₁
A
i₂
B
(Demand for Investment)
i₁
Hint: Interest Rates Down
i₂
Investment
, Investment Increases
.
AGGREGATE DEMAND
Key Point:
The increase in investment causes Aggregate Demand to increase. (See Graph D)
Price Level
Graph D
P
A
B
AD2
AD1
Y₁
Y₂
Real GDP (Output)
Summary
If MONEY SUPPLY increases, the interest rate drops (Graphs A and B).
This drop in interest rates motivates or encourages investment by both households and
businesses. As investment increases (Graph C), causing AGGREGATE DEMAND to also increase
at a given price level, Output (GDP) also increases (Graph D).