But first a little information on the link between interest rates and the money supply is in order. In The evil, ever present, value eroding effect of inflation on… Gameshows I talked about the Reserve Bank of Australia, Australia’s central bank, manipulating interest rates. Here is a brief a brief example of how they do it.
The best way to understand the connection between interest rates and the money supply is just to apply it to yourself. If the central bank were to print lots of money, all else being equal, people would find themselves with more money than they required. And what do we do with extra money that we don’t need. We put it in the bank. Even if you decided to spend the extra money, in that case the business owner who you bought goods from would now find himself with the extra money, and it would eventually find its way into a bank. Those banks that we love to hate then find that people are more willing to deposit money and realise that they can lower interest rates they pay on your deposit. If the banks are paying lower interest rates to get money from depositors, in theory they can charge lower interest rates on their loans. This is the basic link between interest rates and the money supply, and basically all you need to know for the next article. However, for those who want a more in depth explanation of the mechanics of how the central bank does this, read on.
A lot of money is borrowed today with the issuance of bonds. A bond is just an IOU. If Woolworths wants to borrow some money it simply stipulates how much it wants to borrow, when it will pay this amount back, and how much money (interest) it will pay you each period. A bond is even simpler than an ordinary loan in the sense that the amount that is borrowed at the start is not slowly paid back over the life of the loan like your home loan, it is paid back as a lump sum at the end. The dollar value of the interest paid each month is fixed and doesn’t change.
If Woolworths wanted to borrow $5000, and said it would pay you $50 interest every year, you would be receiving $50/$5000=1% interest every year. Now imagine for a moment that someone wanted to buy the bond for $10000. What interest rate are they receiving? The actual dollar value of the interest doesn’t change, it’s still $50. But now the interest rate is $50/$10000=0.5%. this is the critical inverse relationship between interest rates and bond prices. As former rises the latter falls and vice versa. So all that the RBA has to do is change the price of bonds and interest rates will change. They do this using the universal law of supply and demand. They can increase the demand for bonds by buying massive amounts, increasing the price. Of course they buy these massive amounts of bonds with massive amounts of money (the RBA is of course the only entity legally allowed to print money) and this is what brings about the increase in the money supply we talked about earlier.
This is a short run outcome. The RBA cannot in the long run affect the real price of anything. Money printing in the long run can only cause inflation, which has the opposite effect on interest rates. For a run down on the effects of inflation on interest rates, check out So what’s the best way to hedge against inflation?
This is the RBA's primary inflation fighting tool, alluded to in So what’s the best way to hedge against inflation? In Is gold a good hedge against inflation? excess demand caused by money printing (which in Australia can be done only by the RBA) was described as causing inflation (and we now know this would cause an increase in interest rates). Of course the RBA could reduce the money supply and alleviate the excess demand, causing interest rates to rise again.
This can be thought of in another way. If the RBA lowers interest rates (by increasing the money supply) it makes it cheaper for businesses to borrow and increase investment demand, and consumers with mortgages have lower repayments and hence more money to spend in the economy. If this were to get out of hand and inflation took hold, the RBA can raise interest rates, which will reduce business spending, and create that familiar tightening feeling in all home owners throats, alleviating inflation pressures. This demonstrates again how the money supply and interst rates are two sides of the same coin, even as a tool of the RBA.
This is the RBA's primary inflation fighting tool, alluded to in So what’s the best way to hedge against inflation? In Is gold a good hedge against inflation? excess demand caused by money printing (which in Australia can be done only by the RBA) was described as causing inflation (and we now know this would cause an increase in interest rates). Of course the RBA could reduce the money supply and alleviate the excess demand, causing interest rates to rise again.
This can be thought of in another way. If the RBA lowers interest rates (by increasing the money supply) it makes it cheaper for businesses to borrow and increase investment demand, and consumers with mortgages have lower repayments and hence more money to spend in the economy. If this were to get out of hand and inflation took hold, the RBA can raise interest rates, which will reduce business spending, and create that familiar tightening feeling in all home owners throats, alleviating inflation pressures. This demonstrates again how the money supply and interst rates are two sides of the same coin, even as a tool of the RBA.
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