Interest Rate Determination

Suppose the U.S. money supply increases, ceteris paribus. The increase in M^S causes an increase in the real money supply (M^S/P_$), which causes the real money supply line to shift "down" from M^S′/P_$ to M^S″/P_$ (step 1) in the adjacent Money-Forex diagram, Figure 18.9 "Effects of an Increase in the Money Supply". (Be careful here: down in the diagram means an increase in the real money supply). This causes a decrease in the equilibrium interest rate from i_$′ to i_$″ (step 2). The decrease in the U.S. interest rate causes a decrease in the rate of return on dollar assets: RoR_$ shifts from RoR_$′ to RoR_$″ (step 3). Finally, the reduction in the dollar rate of return causes an increase in the exchange rate from E′_$/£ to E″_$/£ (step 4). This exchange rate change corresponds to an appreciation of the British pound and a depreciation of the U.S. dollar. In summary, an increase in the U.S. money supply, ceteris paribus, causes a decrease in U.S. interest rates and a depreciation of the dollar.

Figure 18.9 Effects of an Increase in the Money Supply