Eli5: How do changes in the money supply affect inflation and interest rates in an economy?”
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So the first thing is that all else being equal, more money in an economy means higher prices for goods and services in that economy.
But it gets a little more complicated. You can imagine the economy, looked at from outside, as a big plumbing system with different tanks and reservoirs representing asset classes or places where the money might go.
Increasing the money supply means pushing water into that system. Pressures increase, the money moves around the tanks faster. The amount of money in various reservoirs increases, meaning prices are increasing, inflation is going up.
The tanks can change in size. If the tank with ‘available workers’ is large, say, (if there are lots of unemployed/people looking for work) it will only fill up slowly, meaning wages will increase slowly. If the tank for some good is relatively smaller, or shrinks due to supply of some good being restricted, the money being forced into it will rise faster, meaning inflation in that good or service is rising faster compared to wages.
Trying to control this plumbing system is complicated. One tool policy makers have is to increase or decrease interest rates. Raising interest rates increases the size of the tank labelled ‘money in banks’ as there is an incentive for people to leave their money with banks where it earns interest, and people and companies with debts have to put more of their money into that tank, meaning it can’t go into some other one. Money starts to slosh into that tank from other parts of the system, taking pressure out of the system and reducing inflation. It’s a crude tool, though, as it is difficult for policy makers to control where exactly the pressure will be taken out- typically it is the least powerful or those who are the least broadly invested who suffer.
Reducing interest rates has the reverse effect, pushing money into the system, shrinking (in theory) the tank ‘money in banks’, and having the same effect as pumping money directly into the system. The tanks fill up, and prices rise. Again though, it’s a crude tool, and not everyone profits equally. Once again, it is usually the least powerful or the least broadly invested who are not in a position to take advantage of the rising prices and rather are left behind by them.
(Interestingly, this _didn’t_ happen 2008-20019, because at the same time as lowering interest rates, policy makers insisted banks hang to the money they were printing and recapitalise themselves following the crash. House prices still increased though)
So typically, increases in the money supply leads to high inflation, which leads policy makers to raise interest rates, effectively reducing the money supply and reducing inflation, or at least that’s the idea. In practice the system is very difficult to manage.
The usual economics answer here is to think about money like it’s any other good. There’s demand for money, there’s supply of money, and there’s a “price of money” in the form of how it trades for other goods or in terms of how hard it is to borrow now.
Interest rates and inflation are both measures, in some sense, of the price of money (higher inflation, lower interest rates = lower price of money) relative to other goods. And as with almost all goods, increases in the supply of money reduce the price of money. So in general, high money supply causes high inflation and low interest rates, and low money supply causes low inflation (or deflaration) and high interest rates.
This being an econ-101 question, though, there are numerous exceptions and assumptions built in here that don’t always apply to a real economy.
Imagine a desert island. If I had a banana and u had a orange, I want an orange and u want a banana, we can trade and we both get what we want.
If u suddenly got 2 oranges and I still have 1 banana then the banana is now worth 2 oranges, Because the amount of orange u got is double but the amount of bananas is still 1.
Inflation means there are more dollars chasing the same amount of goods. It is like the orange doubled but the banana is still 1.
Now what interest rates do it alot more complex.
Now imagine a 3rd guy. He has 5 apples.
I no longer want oranges but I want 5 apples for my 1 banana. The 3rd guy doesn’t want bananas but kind of wants oranges but can go without. U ask to borrow the apples but he doesn’t really want oranges, he agrees if u promise to pay back the 5 apples u borrowed with 6 apples later. U trade and then u start again. But o no. He really doesn’t want more oranges so u now have to pay back 7 apples for the 5 u borrowed. U can’t afford to pay back 7 apples so u don’t borrow it.
Interest rates is like that. It makes it more expensive for people to borrow the same amount of money for business and houses. This had alot of other effects as well but beyond a simple explanation
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