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Supply and Demand and Monetary Policy

Supply and Demand and Monetary Policy

While we’ve mainly been discussing consumer goods, the law of supply and demand affects more abstract things as well, including a nation’s monetary policy. This happens through the adjustment of interest rates. Interest rates are the cost of money: They are the preferred tool for central banks to expand or decrease the money supply.

When interest rates are lower, more people are borrowing money. This expands the money supply; there is more money circulating in the economy, which translates to more hiring, increased economic activity and spending and a tailwind for asset prices. Raising interest rates leads people to take their money out of the economy to put in the bank, taking advantage of an increase in the risk-free rate of return; it also often discourages borrowing and activities or purchases that require financing. This tends to decrease economic activity and put a damper on asset prices.

In the United States, the Federal Reserve increases the money supply when it wants to stimulate the economy, prevent deflation, boost asset prices and increase employment. When it wants to reduce inflationary pressures, it raises interest rates and decreases the money supply. Basically, when it anticipates a recession, it begins to lower interest rates, and it raises rates when the economy is overheating.

The law of supply and demand is also reflected in how changes in the money supply affect asset prices. Cutting interest rates increases the money supply. However, the amount of assets in the economy remains the same but demand for these assets increases, driving up prices. More dollars are chasing a fixed amount of assets. Decreasing the money supply works in the same way. Assets remain fixed, but the number of dollars in circulation decreases, putting downward pressure on prices, as fewer dollars are chasing these assets.