The Financial Effects Of Monetary Policy On Interest Rates

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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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