Money and Banking Chapter 5 The Economics of Interest-Rate Fluctuations

Chapter The Economics of Fluctuations CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Describe , at the first level of analysis , the factors that cause changes in the interest rate . List and explain four major factors that determine the quantity demanded of an asset . List and explain three major factors that cause shifts in the bond supply curve . Explain why the Fisher Equation holds that is , explain why the expectation of higher inflation leads to a higher nominal interest rate . Predict , in a general way , what will happen to the interest rate during an economic expansion or contraction and explain why . Discuss how changes in the money supply may affect interest rates . URL books 85

Interest Rate Fluctuations LEARNING OBJECTIVE . As a first approximation , what causes the interest rate to change ?

the gist Interest Rates , you learned ( we hope ! about the time value of money , including how to value ( present value ( yield to maturity , current yield ( the yield to maturity ofa perpetuity ) rate , and real interest rates . You also learned that a change in the interest rate has a profound effect on the value of assets , especially bonds and other types of loans , but also equities and derivatives . In this chapter , we use the generic term bonds throughout . That might not be a very important insight if interest rates were stable for long periods . The fact is , however , interest rates change monthly , weekly , daily , and even , in some markets , by the nanosecond . Consider Figure Yields on Treasury bills , 2008 and Figure Yields on Treasury bills , March 2008 . The first shows yields on Treasury bills from 2001 to 2008 , the second shows a View on just March 2008 . Clearly , there are secular trends as well as ups and downs . Figure Yields on ( bills . URL books 86

Interest rate ( ohm exec go rags 53 exec Date Figure Yields on Treasury bills , March 2008 URL books 87 Interest rate ( 96 ) 90 ' 90 ' Dare You should now be primed to ask , Why does the interest rate ?

In other words , What causes interest rate movements like those shown above ?

In this aptly named chapter , we will examine the economic factors that determine the nominal interest rate . We will ignore , until the next chapter , the fact that interest rates differ on different types of securities . As well learn in Chapter The Economics of Spreads and Yield Curves , interest rates tend to track each other , so by focusing on what makes one interest rate move , we have a leg up on making sense of movements in the literally thousands of interest rates out there in the real world . Another way to think about this is that , in this chapter , we will concern ourselves only with the general level of interest rates , which economists call the interest rate . The keys to understanding why the interest rate changes over time are simple price theory ( supply and demand ) the theory of asset demand , and the liquidity preference framework of renowned early British economist John Maynard Keynes . Like other types of goods , bonds and other instruments trade in markets . The demand curve for bonds , as for most goods , slopes downward the supply curve slopes upward in the usual fashion . There is little mystery here . The URL books ( 88

supply curve slopes upward because , as the price of bonds increases ( which is to say , as we learned in Chapter Interest Rates , as their yield to maturity decreases ) borrowers ( sellers of securities ) will supply a higher quantity , just as producers facing higher prices for their wares will supply more cheese or automobiles . As the price of bonds falls , or as the yield to maturity that sellers and borrowers offer increases , sellers and borrowers will supply fewer bonds . Why sell em if they aren going to fetch much ?

The demand curve for bonds slopes downward for similar reasons . When bond prices are high ( yields to maturity are low ) few will be demanded . As their price falls ( their yields increase ) investors ( buyers ) want more of them because they are increasingly good deals . The ofa bond and the quantity that will be traded is determined , ofcourse , by the intersection of the supply and demand curves , as in Figure Equilibrium in the bond market . The equilibrium price prevails in the market because , if the market price were temporarily greater than , the market would be glutted with bonds . In other words , the quantity of bonds supplied would exceed the quantity demanded , so sellers of bonds would lower their asking price until equilibrium was restored . If the market price temporarily dipped below , excess demand would prevail ( the quantity demanded would exceed the quantity supplied ) and investors would bid up the price of the bonds to the equilibrium point . Figure in the ) I ( URL books 89

Price of Bonds , Interest Rate . i ( i ) 950 800 750 100 200 300 400 500 Quantity of Bonds , millions ) As with other goods , the supply and demand curves for bonds can shift right or left , with results familiar to principles ( Econ 101 ) students . If the supply of bonds increases ( the supply curve shifts right ) the market price will decrease ( the interest rate will increase ) and the quantity of bonds traded will increase . If the supply of bonds decreases ( the supply curve shifts left ) bond prices increase ( the interest rate falls ) and the equilibrium quantity decreases . If the demand for bonds falls ( the demand curve shifts left ) prices and quantities decrease ( and the interest rate increases ) If demand increases ( the demand curve shifts right ) prices and quantities rise ( and the interest rate falls ) URL books , 90

KEY TAKEAWAYS The interest rate changes due to changes in supply and demand for bonds . Or , to be more precise , any changes in the slopes or locations of the supply demand curves for bonds ( and other financial instruments ) lead to changes in the equilibrium point ( and ) where the supply and demand curves intersect , which is to say , where the quantity demanded equals the quantity supplied . URL books 91

Shifts in Supply and Demand for Bonds LEARNING OBJECTIVE . What causes the supply and demand for bonds to shift ?

supply and demand curves around can , out why the curves shift is the interesting part . Determining the shape and slope of the curves is interesting too , but these details will not detain us here . Movements along the curve , or why the supply curve slopes upward and the demand curve downward , were easy enough to grasp . Determining why the whole curve moves , why investors are willing to buy more ( or fewer ) bonds , or why borrowers are willing to sell more ( or fewer ) bonds at a given price is a bit more involved . Let tackle demand first , then we will move on to supply . Wealth determines the overall demand for assets . An asset ( something owned ) is any store of value , including financial assets like money , loans ( for the lender ) bonds , equities ( stocks ) and a potpourri of derivatives and assets like real estate ( land , buildings ) precious metals ( gold , silver , platinum ) gems ( diamonds , rubies , emeralds ) hydrocarbons ( oil , natural gas ) and ( to a greater or lesser extent , depending on their qualities ) all other physical goods ( as opposed to bads , like pollution , or freebies , like air ) As wealth increases , so too does the quantity demanded of all types of assets , though to different degrees . The reasoning here is almost circular if it is to be maintained , wealth must be invested in some asset , in some store of value . In which type of asset to invest new wealth is the difficult decision . When determining which assets to hold , most economic entities ( people , firms , governments ) care about many factors , but for most investors most of the time , three relative return , risk , and paramount . We discussed these concepts , you may recall , in Chapter The Financial System . Expected relative return is the ex ante ( before the fact ) belief that the return on one asset will be higher than the returns of other comparable ( in terms of risk and liquidity ) assets . Return is a good thing , ofcourse , so as expected relative return increases , the quantity demanded ofan asset also increases . That can happen because the expected return on the asset itself increases , because the expected return on decreases , or because of a combination thereof . Clearly , two major URL books 92

factors discussed in Chapter Interest Rates will affect return expectations and hence the demand for certain assets , like bonds expected interest rates and , via the Fisher Equation , expected . If the interest rate is expected to increase for any reason ( including , but not limited to , expected increases in ) bond prices are expected to fall , so the quantity demanded will decrease . Conversely , if the interest rate is thought to decrease for any reason ( including , but not limited to , the expected taming of ) bond prices are expected to rise , so the quantity demanded will increase . Overall , though , calculating relative expected returns is sticky business that is best addressed in more specialized financial books and courses . If you want an introduction , investigate the capital asset pricing model ( and the arbitrage pricing theory ( APT ) As we learned in Chapter Interest Rates , calculating return is not terribly and neither is comparing returns among a variety of assets . What tricky is forecasting future returns and making sure that assets are comparable by controlling for risk , among other things . Risk is the uncertainty of an asset returns . It comes in a variety , all ofthem unsavory , so as it increases , the quantity demanded ofan asset decreases , In Chapter Interest Rates , we encountered two types of risk default risk ( aka credit risk ) the chance that a contract will not be honored , and interest rate risk , the chance that the interest rate will rise and hence decrease a bond or loan price . An offsetting risk is called reinvestment risk , which bites when the interest rate decreases because coupon or other interest payments have to be reinvested at a lower yield to maturity . To be willing to take on more risk , whatever its , rational investors must expect a higher relative return . Investors who require a much higher return for assuming a little bit of risk are called . Those who will take on much risk for a little higher return are called , or . Investors who take on more risk without compensation are neither nor , but rather irrational in the sense discussed in Chapter Rational Expectations , Efficient Markets , and the Valuation of Corporate Equities . Risks can be idiosyncratic that is , they can be pertinent to a particular company , sectoral ( pertinent to an entire industry , like trucking or restaurants ) or systemic ( Liquidity risk occurs when an asset can not be sold as quickly or cheaply as expected , be it for idiosyncratic , sectoral , or systemic reasons . This , too , is a serious risk because liquidity , or ( to be ) liquidity relative to other assets , is the third major determinant URL books 93

demand . Because investors often need to change their investment portfolio or ( spend some of their wealth on consumption ) liquidity , the ability to sell an asset quickly and cheaply , is a good thing . The more liquid an asset is , therefore , the higher the quantity demanded , all else being equal . During the crisis that began in 2007 , the prices of a certain type of bond collateralized by subprime mortgages , loans collateralized with homes and made to relatively risky borrowers , collapsed . In other words , their yields had to increase markedly to induce investors to own them . They dropped in price after investors realized that the bonds , a type of security ( ABS ) had much higher default rates and much lower levels of liquidity than they had previously believed . Figure Variables that demand for bonds summarizes the chapter discussion so far . Figure Variables that bonds So much for demand . Why does the supply curve for bonds shift to and fro ?

There are many reasons , but the three main ones are government budgets , expectations , and general business conditions . When governments run budget deficits , they often borrow by selling bonds , pushing the URL books . 94 supply curve rightward and bond prices down ( yields up ) When governments run surpluses , and they occasionally do , believe it or not , they redeem or buy their bonds back on net , pushing the supply curve to the left and bond prices up ( yields down ) all else being equal . For historical time series data on the national debt , which was usually composed mostly of bonds , browse . Stop and Think Box You are a for . What , if anything , appears wrong in the following sentence ?

How do you know ?

Recent increases in the of investments , expectations , and government surpluses will surely lead to increased bond supplies in the near Government deficits , not surpluses , lead to increased bond supplies . The expectation of higher , other factors held constant , will cause borrowers to issue more bonds , driving the supply curve rightward , and bond prices down ( and yields up ) The Fisher Equation , i , i , explains this nicely . If the expectation term increases while nominal interest rate i stays the same , the real interest rate i must decrease . From the perspective of borrowers , the real cost of borrowing falls , which means that borrowing becomes more attractive . So they sell bonds . Borrowing also becomes more attractive when general business conditions become more favorable , as when taxes and regulatory costs decrease or the economy expands . Although individuals sometimes try to borrow out of weakness or desperation , relatively few such loans are made because they are high risk . Most economic entities borrow out of strength , to expansion and engage in new projects they believe will be profitable . So when economic prospects are good , taxes are low , and regulations are not too costly , businesses are eager to borrow , often by selling bonds , shifting the supply curve to the right and bond prices down ( yields up ) Figure Variables that determine the supply of bonds summarizes the chapter discussion so far . Figure ( that ( the I on ( Is URL books es

As Yoda might say , Pause here , we must to make sure we re on track . Try out these questions until you are comfortable . Remember that the condition holds in each . EXERCISES . What will happen to bond prices if stock trading commissions decrease ?

Why ?

What will happen to bond prices if bond trading commissions increase ?

Why ?

What will happen to bond prices if the government implements tax increases ?

Why ?

If government revenues drop significantly ( and remember all else stays the same , including government expenditures ) what will likely happen to bond prices ?

Why ?

If the government guaranteed the payment of bonds , what would happen to their prices ?

Why ?

What will happen to bond prices if the government implements regulatory reforms that reduce regulatory costs for businesses ?

Why ?

If government revenues increase significantly , what will likely happen to bond prices ?

Why ?

What will happen to bond prices if terrorism ended and the world nations unilaterally disarmed and adopted free trade policies ?

Why ?

What will happen to bond prices if world peace brought substantially lower government budget deficits ?

If you already figured out that expected inflation will decrease bond prices , and increase bond yields , by both shifting the supply curve to the right and the demand curve to the left , as in Figure Expected inflation and bond prices below , kudos to you ! Figure inflation and bond prices books 96

Price of Bonds , Interest Rate , i ( increases ?

i ) Quantity of Bonds , If you noticed that the response of bond prices and yields to a business cycle expansion is indeterminate , As noted above , a boom shifts the bond supply curve to the right by inducing businesses to borrow and thus take advantage of the bonanza . Holding demand constant , that action reduces bond prices ( raises the interest rate ) But demand does not stay constant because economic expansion increases wealth , which increases demand for bonds ( shifts the curve to the right ) which in turn increases bond prices ( reduces the interest rate ) The net effect on the interest rate , therefore , depends on how much each curve shifts , as in Figure Business cycle expansion and bond prices . Figure . cycle expansion and bond prices URL books 97

Price of Bonds , Interest Rate , i ( increases ) i increases ) Quantity of Bonds , In reality , the first scenario is the one that usually wins out during , the interest rate usually rises , and during , it . For example , the interest rate fell to very low levels during the Great Depression and during Japan extended economic funk in the KEY TAKEAWAYS The demand curve for bonds shifts due to changes in wealth , expected relative returns , risk , and liquidity . Wealth , returns , and liquidity are positively related to demand risk is inversely related to demand . Wealth sets the general level of demand . Investors then trade off risk for returns and liquidity . The supply curve for bonds shifts due to changes in government budgets , inflation expectations , and general business conditions . Deficits cause governments to issue bonds and hence shift the bond supply curve right surpluses have the opposite effect . URL books 98

Expected inflation leads businesses to issue bonds because inflation reduces real borrowing costs , decreases in expected inflation or deflation expectations have the opposite effect . Expectations of future general business conditions , including tax reductions , regulatory cost reduction , and increased economic growth ( economic expansion or boom ) induce businesses to borrow ( issue bonds ) while higher taxes , more costly regulations , and shift the bond supply curve left . Theoretically , whether a business expansion leads to higher interest rates or not depends on the degree of the shift in the bond supply and demand curves . An expansion will cause the bond supply curve to shift right , which alone will decrease bond prices ( increase the interest rate ) But also cause the demand for bonds to increase ( the bond demand curve to shift right ) which has the effect of increasing bond prices ( and hence lowering bond yields ) Empirically , the bond supply curve typically shifts much further than the bond demand curve , so the interest rate usually rises during and always falls during . sectA apt ?

pid refer japan sid URL books 99 Liquidity Preference LEARNING OBJECTIVE . In Keynes liquidity preference framework , what effects do inflation expectations and business and have on interest rates and why ?

Elementary price theory and the theory of asset demand go a long way toward helping us to understand why the interest rate bobbles up and down over time . A third aid to our understanding , the liquidity , strengthens our conviction in the robustness ofour analyses and adds nuance to our understanding . In this model there are but two assets , money , which earns no interest , and bonds , which earn some interest greater than zero . The assumption worry you . Economic models deliberately simplify reality to concentrate on what is most important . Furthermore , in the model , the markets for bonds and money are both in equilibrium , so we can study the latter to learn about the former . Graphically , the model is most easily represented as shown in Figure Equilibrium in the market for money . It is a little than what you are used to because the vertical axis is the interest rate , Other than that , the graph works exactly like a traditional supply and demand graph . The money demand curve slopes downward in the usual way because , as the interest rate increases , the quantity of money demanded decreases . Why hoard cash when you can buy bonds with it and make beaucoup bucks ?

As the interest rate declines , though , the quantity of money demanded will increase as the opportunity cost of holding bonds decreases . Why own bonds , which of course aren as liquid as money , if they pay squat ?

The supply of money in this model is represented by a vertical line . It can slide left and right if the monetary authority ( like a government central bank , of which you will learn more in Chapter 13 Central Bank Form and Function ) sees to decrease or increase the money supply , respectively , but the quantity supplied does not vary with changes in the interest rate . In more technical parlance , the supply of money in the model is perfectly inelastic . Figure in the ( money URL books 100

Interest Rate , i ( 30 20 10 100 200 300 400 500 600 Quantity of Money , billions ) The intersection of the money supply and demand curves reveals the market rate of interest . Equilibrium will be reached because , if the interest rate exceeds the equilibrium rate ( i ) the quantity of money demanded will be less than the quantity of money supplied . People will use their excess money to buy bonds , which will drive bond prices up and yields down , toward the equilibrium . Conversely , if the interest rate is below the equilibrium rate , the quantity of money demanded exceeds the quantity supplied . People would therefore sell bonds for cash , decreasing bond prices and increasing bond yields until the equilibrium is reached . The equilibrium interest rate i changes , of course , with movements of either curve . If the money supply increases ( the money supply curve shifts right ) the interest rate falls , That makes URL books , 101

sense because there is more money to lend . If the money supply decreases , by contrast , the interest rate increases because there is less money to lend ( and the demand stays the same ) The demand for money can also change . If the demand curve shifts right ( and the money supply stays constant ) higher demand for money will spell a higher interest rate . If it shifts left , lower money demand will cause the interest rate to decrease . Again , this makes great sense intuitively . The interesting issue here is why the curves move , not what happens when they do . According to the model , the money demand curve two major reasons , income level , both ofwhich are positively related to demand . In other words , as income increases or the price level rises , the demand for money increases ( shifting the money demand curve to the right and thus increasing the interest rate ) Money demand increases with income for two reasons because money is an asset and hence demand for it increases with wealth , as described above . Perhaps more important , money demand increases because economic entities transact more as incomes rise , so they need more money to make payments . increases money demand because people care about real balances , not nominal ones . As the price level rises , the same sum of money can not buy as much , so people demand more money at any given interest rate ( ie , the money demand curve shifts right ) and , in accord with the Fisher Equation , the interest rate rises . Stop and Think Box You are a consultant for a company considering issuing bonds when you find the following message in your inbox From Reuters News Service Re Economists Express Concern Over Is beginning to awaken from its long slumber ?

Some economists are beginning to detect signs of strain . They worry that recent reports were pushed down by unusually large price decreases in certain areas , which buck recent trends and are unlikely to recur . Absent those drops , the overall numbers would have edged higher . Other economists argue that many companies are just beginning to feel the bite of skyrocketing energy costs . Businesses are unlikely to watch URL books 102

margins continue to shrink without forcing through price increases . Other companies have locked in lower energy costs by skillfully using futures markets , but those options are set to expire , leaving the businesses What do you advise your clients regarding their bond issue deliberations ?

Why ?

According to Irving Fisher , when expected rises , the interest rate will rise . This Fisher effect , which is by both the theory of asset demand and Keynes liquidity preference framework , suggests that the company will have to pay a higher yield on its bonds than anticipated because the higher expected will reduce the expected return on bonds relative to real assets , shifting the demand curve to the left . Also , the real cost of borrowing will decrease , causing the quantity of bonds supplied to the market to increase and the supply curve to shift to the right . Both reduced demand and increased supply leads to a decrease in bond prices , that is , an increase in bond yields . Or , in Keynes framework , the demand for money increases with expectations because people want to maintain real money balances . Any way you slice it , the company is facing the prospect of paying higher yields on its bonds in the near future . Figure of the supply and demand for money summarizes the chapter discussion so far . And its time again to complete some problems and make sure you re following all this . Figure ofthe supply and money EXERCISES . What will happen to the interest rate if the monetary authority issues more money ( or money at a faster rate than usual ) URL books

KEY TAKEAWAYS If a steep recession sets in , what will happen to the interest rate ?

The government has decided to drastically slow the rate of money growth . What will happen to the interest rate ?

If war breaks out in the Middle East , thus causing energy prices to soar and the prices of most goods and services to increase steeply , what will happen to the interest rate ?

If the war in number suddenly ceases , causing energy and other prices to actually decline ( deflation ) what will the interest rate do ?

The expectation of higher inflation causes the bond supply curve to shift right and the bond demand curve to shift left , both of which depress bond prices ( that is , cause the interest rate to increase ) In the liquidity preference framework , expectations of higher prices cause the demand for money to shift to the right , raising the interest rate . A business expansion will cause interest rates to increase by increasing the demand for money ( causing the money demand curve to shift right ) A recession will cause interest rates to decrease by decreasing the demand for money ( causing the money demand curve to shift left ) economics ) URL books 104

Predictions and Effects LEARNING OBJECTIVE . How does the interest rate react to changes in the money supply ?

We re almost there ! As noted above , the liquidity preference framework predicts that increasing the money supply will decrease the interest rate . This liquidity , as it is called , holds , including income , actual , and expected , remain the same . In the distant past , the condition indeed held , as suggested in Figure United States money meter , ca . 1800 . The excerpt in the is taken from an early economic treatise Figure ( tur . ca . 1800 URL books 105

UNITED STATES FINANCIAL To explain the effects of loans , and sinking funds , on the physical and moral abilities and energies of a commonwealth . Foreign loans of specie may the meter . Specie level or average of commercial Europe in 1805 . Money will gently begin to off before it reaches the general level . Real estates sell at twenty to thirty years purchase . Lands higher and near their acme . Interest percent . Science extending . All real estate at a fair price , and labour also . Commerce brisk , the arts , heat prevails . Back lands rise , labour lowers , interest six per cent . Industry gains ground with commerce and agriculture . Commerce , and with it every thing improves . Back lands begin to sell at two dollars , in small parcels . Money reaches the middle country all labour very high , in 1800 . Money still centers in the cities usury twelve percent , in idleness abounds usury at twenty to thirty per cent Extreme distress , universal distrust , ment in danger . dollars for each person the highest specie level . The principal drains are , by sinking funds , or of foreign loans in bills or specie . URL books 106

The key point is that , as the money supply ( here presented in per capita terms , from to 25 per person ) increases , the interest rate falls , as the model predicts . At per person usury , an antiquated term for interest , is at twenty to thirty At , it falls to 12 percent , as in 1806 . At per head , it sinks to percent , while at 12 , it goes to , and at 15 , to or . Real estates sell at twenty five to thirty years purchase is an way of stating this . Think about it in terms of the perpetuity equation you learned in Chapter Interest Rates i , where is and 25 or 30 times that , 25 or 30 times the annual income generated by the asset . i and i . Most of the world was on a commodity standard ( gold silver ) then , so the money supply was , expanding and contracting automatically , as explained in Chapter Money . At 20 or so per person , money began to off , to be exported , and would never exceed 25 . So monetary expansion did not cause prices to rise permanently the expectation was one of zero net in the medium to long term . Today , matters are rather different . Government entities regulate the money supply and have a habit of expanding it because doing so prudently increases economic growth , employment , incomes , and other good . Unfortunately , expanding the money supply also causes prices to rise almost every year , with no reversion to earlier levels . When the money supply increases today , therefore , often actually occurs and people begin to expect in its wake . Each of these three , called the income , price level , and expected , causes the interest rate to rise for the reasons discussed above . When the money supply increases , the liquidity effect , which lowers the interest rate , battles these three effects . Sometimes , as in the distant past , the liquidity effect wins out . When the money supply increases ( or increases faster than usual ) the liquidity effect wins out , and the interest rate declines and stays below the previous level . Sometimes , often in modern industrial economies with independent central banks , the liquidity effect wins at and the interest rate declines , but then incomes rise , expectations increase , and the price level actually rises , eventually causing the interest rate to increase above the original level . Finally , sometimes , as in modern undeveloped countries with weak central banking institutions , the expectation of is so strong and so quick that it overwhelms the liquidity effect , driving up the interest rate immediately . Later , after incomes and the price level increase , the interest rate soars yet URL books ' 107

higher . Figure Money supply growth and nominal interest rates summarizes this discussion graphically . Figure Money supply and nominal URL books 108 Interest Rate , a ) Liquidity effect larger than other effects Liquidity Income , Effect and Effects Interest Rate , I ( Liquidity effect smaller than other effects and slow adjustment of expected Liquidity Income , Effect and Effects Interest Rate , i i ( Liquidity effect smaller than effect and fast adjustment of expected inflation Liquidity and Income and Level Effects Effects URL books again 109

Stop and Think Box was a staunch supporter of free Famed monetary economist and Nobel laureate Milton markets and a critic of changes in the price level , particularly the rampant of the . He argued that government monetary authorities ought to increase the money supply at some known , constant rate . If was so worried about price level changes , why didn he advocate permanently fixing the money supply ( By the , the interest rate would have risen higher and higher as the demand for money increased due to higher incomes and even simple population growth . Only ( decreases in the price level ) could have countered that tendency , but , knew , was as pernicious as . A constant rate of growth , he believed , would keep the price level relatively stable and interest rate less frequent or severe . The ability changes in the interest rate is a rare . Professional interest rate forecasters are rarely right on the mark and often astray , and halfthe time they don even get the direction ( up or down ) right . That what we expect if their forecasts were determined by a coin ! We discuss why this might be in Chapter Rational Expectations , Efficient Markets , and the Valuation of Corporate Equities . Therefore , we don expect you to be able to predict changes in the interest rate , but we do expect you to be able to them . In other words , you should be able to narrate , in words and appropriate graphs , why past changes occurred . You should also be able to make predictions by invoking the assumption . KEY TAKEAWAYS Under a commodity money system such as the gold standard , an increase in the money supply decreases the interest rate and a decrease in the money supply increases it . Under a floating or fiat money system like we have today , an increase in the money supply might induce interest rates to rise immediately if inflation expectations were strong or to rise with a lag as actual inflation took place . URL books ( 110

( referrer parent issue 15 URL books 111 Suggested Reading , Keynes an Monetary Policy , Finance and Uncertainty Reassessing Liquidity Preference Theory . New York , 2009 . Evans , Michael . Practical Business Forecasting . John Wiley and Sons , 2002 . Milton . The Optimum Quantity , Aldine Transaction , 2005 . URL books 0791 ) 112