What Are The Different Ways In Which Money Supply Can Affect The Interest Rate?

The supply of money has a somewhat ambivalent relationship with the interest rate.  In some ways, it positively affects the interest rate whereas in other cases the repercussions are downright negative.  There are a number of ways in which the supply of money can affect the interest rate.  More precisely, there are three types of effects that the money supply can create on the interest rates.  Those effects are namely the liquidity effect, the income effect and the price expectations effect.

As far as liquidity goes, it is the ability of an asset to be transformed into cash.  In this very case, the money supply shares a negative relationship with the interest rate.  Liquidity will definitely increase money supply, which will leave people with lots of cash, which they are ready to borrow.  As a result of supply exceeding the demand for borrowing, the interest rate will decline proving the liquidity effect right.

Coming to the income effect, this case goes in pure contrast with the previous one.  The increase in money supply means a raise in income naturally.  In relation to that, it causes a rise in the equilibrium rate of interest.

As for the price expectation effect, it has two cases of concern.  If money supply increases in an economy that is performing beneath its capacity, then it will stimulate output, employment and production.  But if money supply increases in an economy where the performance is fully in harmony with the capacity, then the expectation of prices to rise (inflation) grows   That, in turn, increases the interest rate.