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Syllabus: Interest rate determination (by the market)

Syllabus: Explain, using a demand and supply of money diagram, how equilibrium interest rates are determined, outlining the role of the central bank in influencing the supply of money.

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How can the Central Bank increase the supply of money?

This is a complicated topic, because there are many different measures of money; each differing according which assets are actually considered to be 'money'.

Money in its most liquid form consists of cash and is demanded as a medium of exchange for transactionary purposes, in other words for buying things. You can also buy things with cheques and debit cards so current accounts (Conta Currentes) are also classified as money. Because deposit accounts (savings accounts - poupanças) are so easily converted to current accounts to use for purchasing goods and services, these are classified as `broad money´.

Other more less-liquid assets, such as short-term government securities, treasury bills and long dated government securities are often considered to be money from commercial banks point of view.

The most straightforward way for Central Banks to increase the money supply is to:

  • Print more cash to finance government spending which is then passed on in the circular flow of income (not a realistic way in this day and age), or
  • Buy back government securities such as treasury bills and bonds - which is a more realistic way - bills and bonds go to central bank and money is injected into the economy (referred to as open market operations).
  • Allow commercial banks to hold fewer reserves to support their lending (Reserve asset ratio)