The Financial Effects Of Monetary Policy On Interest Rates



In summary of Michael Darby’s article involving , three specific effects emerge as the most influential. Darby suggests that an increase in the rate of growth of the money supply leads to a pattern of changes in the interest rate that reflects the interaction of the liquidity, income, and expectations effects which vary over time in relative strength. The liquidity effect involves the immediate impact of monetary on interest rates. The income effect pertains to the growth path rate of price levels. Lastly, the expectations effect deals with expected rates of inflation. These three entities will provide a basis for the analysis involved in this paper. Regression models will then be ...

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interest rate must fall over time to restore equality of money supply and demand. The immediate impact of monetary policy on the interest rate is known as the liquidity effect. However, over time “aggregate demand for goods is increased both by direct impacts of the falling interest rate on investment demand and of excess cash balances on purchases of consumers’ durable goods and by indirect multiplier effects of the direct increase in spending” (Darby 1975). This then contributes to an increase in income and prices, which then increases the demand for money. This effect is depicted in graph #1 below.
Regarding the income effect, its theory is derived from “the combined impact on the nominal interest rate of the temporary increase in real income above its equilibrium growth path and the permanent increase in the growth path of the price level” (Darby 1975). Darby suggests that the low interest rate causes a high aggregate demand. Companies borrow money to invest and then ...

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well as the annual regression (80-99). According to Darby, immediately after the money supply is increased, the result will be a fall in the nominal rate so as to restore the equality of the money supply and money demand. As the supply of money increases and shifts right, prices fall since more money is in circulation and is easier to obtain. Thus Darby concludes a negative relationship between the growth rate of money supply and the nominal interest rate. Referring to the monthly regression (80-99), the coefficient is –8.20, which indicates a negative relationship between money supply and the nominal interest rate. Thus this regression model supports Darby’s argument. Since the ...

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PAPER DETAILS
Added: 7/21/2007 01:45:12 PM
Category: Economics
Type: Premium Paper
Words: 1334
Pages: 5

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