P7, section 3. Chapter 11, controlling inflation it's clear to understand the underlying rationale that reducing interest rates → increase demand for money → increase money supply → inflation. but, according to the quantity theory of money, an increase in the money supply → increase in prices / interest rates. a little bit confuse that how to understand the two angles? seemingly contradictory. thanks a lot!
I'm not sure which two angles you're referring to. The quantity theory of money relates the money supply to the level of prices, hence supply/demand in money to inflation. This is more or less what you've described in your post, apart from the idea that increases in money supply lead to increases in interest rates. Where is this idea from? It's not something I'm familiar with. An alternative theory of money you might be getting confused with is The Notorious B.I.G. theory of money, which famously relates mo' money to mo' problems.
I agree - I think these are the same ideas? If inflation gets out of hand as a result of pumping money into an economy then interest rates may have to increase to control that. But the relationship described by the quantity theory of money is between money supply and the price of goods - and hence inflation.
My question is that, according to the quantity theory of money, an increase in money supply would lead to an increase in price of money, and interest rates are deemed as the price of money, am i right? therefore, it derives that an increase in money supply results in an increase in interest rates, right? but, from the textbook, reducing interest rates is to increase money supply. i mean, are such two arguments contradict each other? or how to understand it? thanks!
I think the first statement you make here is incorrect? An increase in the supply of something would reduce its price, all else being equal.
I seems got your points, that, the statement in the course notes, page 7, Chapter 11, "an increase in the money in circulation will cause an increase in prices", the "prices" here indicates the prices of general goods in the economy, not the price of the money, i.e. the interest rates, am i right? if my this understanding is true, then my confuse above would be resolved.
Hi all, On chapter 11, flash card 4. Q:"The main economic influences on short-term interest rates are government policies. Outline three such government policies and the link between them and low short-term interest rates." The answer (as above) clearly states that low interest rates eventually leads to higher inflation through increased demand for money and spending. This makes sense to me and is what I have been taught for several years in economics (I think!). On chapter 11, flash card 11 "Explain how expectations of inflation may influence equity prices." The answer states: "Indirect effects of inflation: High inflation is often associated with high interest rates, which can be unfavorable for economic growth, which would reduce equity prices." I don't understand the contradiction here. How can high interest rates lead to high inflation? If interest rates are high, people will be encouraged to save and not take out 5 loans on their houses, overall inflation would be low. I can only imagine this would be the case if they already had 5 loans on their houses, i.e. after a long period of low interest rates. Can you confirm if this is a mistake in the flash cards? Or if economics is, as I suspected all along, a load of mumbo jumbo.
Hi - there is certainly an element of that in relation to traditional economics! However, this point is sound. It isn't saying that high interest rates lead to high inflation. It says that 'high inflation is often associated with high interest rates'. We tend to have longish periods of low interest rates & low inflation (as we have been in now for many years in the UK & Europe) and of high interest rates & high inflation (eg 1970s / early 1980s). While inflation is low (and stable), interest rates can stay low. When inflation gets high, interest rates need to be high in order to keep it from escalating out of control. [Bear in mind that when we talk about interest rates we normally mean nominal interest rates, which broadly = real interest rates + expected inflation, so you can see the link to some extent there as well.]
Hi Lindsay thanks for responding. That does make sense to me too. Just another case of me not reading the point properly. I withdraw my mumbo jumbo comment.
