Because the Money Supply Is Independent of the Interest Rate, Is It a Vertical Line?

The relationship between money supply and interest rates is a fundamental concept in economics. A common question is whether the money supply curve should be represented as a vertical line, given that central banks control its volume rather than letting it fluctuate with interest rate changes. This has implications for monetary policy and how interest rates are determined in financial markets.

To understand why the money supply is often depicted this way, it’s important to examine the role of central banks, the mechanics behind the supply curve’s shape, and how demand factors into setting interest rates.

Central Bank’s Role in Money Volume

Monetary authorities regulate the amount of money circulating in an economy through tools that influence liquidity and financial stability. One primary mechanism is open market operations, where central banks buy or sell government securities to adjust bank reserves. Purchasing securities injects money into the banking system, increasing supply for lending. Selling securities does the opposite, tightening financial conditions.

Reserve requirements also affect how much money banks can create through lending. By setting minimum reserves, central banks indirectly control credit expansion. A lower requirement allows more lending, increasing money supply, while a higher requirement restricts it. Though less commonly adjusted in modern policy, this remains a tool for managing liquidity.

The discount rate—the interest rate at which banks borrow from the central bank—also plays a role. A lower rate encourages borrowing and lending, expanding money supply, while a higher rate discourages it, leading to contraction.

Why the Supply Curve Is Vertical

The money supply curve is shown as a vertical line because its quantity is determined by policy decisions rather than reacting to interest rate fluctuations. Unlike most goods or services, where supply changes based on price movements, the total money available in an economy is set by central bank actions. Regardless of interest rate shifts, the overall supply remains unchanged in the short term.

Central banks establish monetary targets based on economic conditions like inflation or employment. Once set, money supply does not expand or contract in response to interest rate changes alone. Adjustments occur only when policymakers intervene to alter liquidity conditions.

Money creation is not directly influenced by borrowing and lending in the way demand-driven markets operate. While interest rates affect how much money individuals and businesses wish to hold or borrow, they do not dictate total supply at a given moment. The banking system distributes money but does not independently determine its overall volume.

Rate Determination Through Demand

Interest rates are shaped by how much money people and businesses want to hold relative to what is available. When demand rises, individuals and firms prefer more cash for transactions, savings, or investments. This leads to higher borrowing costs as financial institutions adjust to meet demand. When demand weakens, banks lower rates to encourage borrowing and spending.

Inflation expectations play a key role. If people anticipate rising prices, they hold less cash since its purchasing power declines, increasing spending and investment. This reduces money demand and lowers rates. Conversely, in periods of expected deflation or uncertainty, individuals and businesses prefer liquidity, increasing demand and pushing rates higher.

Liquidity preferences also influence rates. Businesses making large investments or consumers making big purchases require more accessible funds, raising short-term borrowing costs. During economic slowdowns, reduced business activity and cautious consumer behavior lessen the need for immediate liquidity, leading to lower rates as financial institutions compete to lend.