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What Are the Effects of an Increase in Money Supply?

In the United States, the Federal Reserve may increase the money supply.
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  • Written By: Troy Holmes
  • Edited By: W. Everett
  • Last Modified Date: 25 September 2014
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The national money supply is the amount of money available for consumers to spend in the economy. In the United States, the circulation of money is managed by the Federal Reserve Bank. An increase in money supply causes interest rates to drop and makes more money available for customers to borrow from banks.

The Federal Reserve increases the money supply by buying government-backed securities, which effectively puts more money into banking institutions. An increase in paper money reduces the value of the U.S. dollar, but increases the money banks can lend to consumers. When banks have more money to loan, they reduce the interest rates consumers pay for loans, which typically increases consumer spending because money is easier to borrow. The government will request an increase in the money supply when the economy begins to slow to spur additional spending by consumers and build confidence in the economy.

An increase in money supply can also have negative effects on the economy. It causes the value of the dollar to decrease, making foreign goods more expensive and domestic goods cheaper. With the complex global economy, this can ripple out and affect other nations. Steel, automobiles, and building materials can all cost more. As a result, the prices for home building and real estate increase because of increased material and building expenses. It does make it easier for customers to get loans, however, because banks are more willing to loan money.

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Successfully managing the global economy requires effective monetary polices. An increase in the money supply is only one of many options available to government policy makers. They can also modify tax rates, adapt foreign trade restrictions, modify bank reserve requirements, and change the federal interest rate.

If an increase in money supply is too drastic, it can lead to deflation in the economy because the value of the country's currency can drop when compared to that of other countries. This causes products of the home nation to become cheap and attractive to foreign investment.

The Federal Reserve in the US has been monitoring the money supply for many decades. This supply ratio has a direct effect on the growth of the economy and gross domestic product. The goal is to balance the available money with interest rates to ensure steady growth.

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discographer
Post 3

@fify-- Thanks for the comment.

If I understand correctly, you are saying that increasing the money supply is not a bad policy as long as the government also puts in place some other policies that you mentioned.

So with my mortgage example, what did the government do wrong (or did not do) that resulted in this crises?

You also made a very good point with domestic goods. If foreign goods become too expensive for us to purchase, we should have alternative domestic products to take its place.

But I think that this is not very easy to do because, just as an example, not everyone wants to buy an American car. Some people prefer Japanese cars because they feel that it is better quality. So I don't think that consumers will be very happy with decreasing exports, even if it is very expensive to purchase. I think this is another reason why increasing the money supply is not a good idea.

fify
Post 2

@anamur-- You are not wrong because when the money supply increases, gross national product (GNP) increases but the deficit doesn't go away.

The additional policies that the government follows afterward are very important. We know that the exchange rate is going to fall but to be able to cover deficits, the government has to lower the number of goods in the market that are imported. If it does this, then, not only will the GNP increases again, but the deficits will also be taken care of.

The other point that I would like to make is that, even though domestic prices fall and it makes it easier to buy and export domestic goods, this will benefit the economy if we have enough domestic goods. If there is a problem with production and supply, it won't have as good an effect on the economy as it could.

serenesurface
Post 1

It's been a really long time since I took an economy course, but I think that increasing the money supply to help relieve the economy is a short-term solution that does more bad than good in the long term.

Wasn't this the policy that led to the mortgage crises in the last several years? When the money supply increased and interest rates went down, everyone took mortgages to buy a house. But this was only a short term solution. It improved the economy for a while, but then, interest rates started rising so drastically that house owners could not afford to pay their mortgage and they lost their houses.

I think that increasing the money supply is a policy that helps the government save face in the short term. But, in the longer term, we realize that it wasn't such a good idea as it appeared to be.

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