Possible Unexpected Scenarios When Increase/Reduce Money Supply.

Although the main objective to control money supply is to either stimulate or cool down the economy. Sometimes things do not work as it supposed to be. Let’s explore various scenarios.

Scenario 1 – Country In Recession

With the country slipping into recession, central bank decided to reduce interest rate to stimulate the economy to encourage spending and investment. However, disaster strike, like a major earthquake; terrorist attack; or banks going into default for whatever reason. The public went into panic mode, rush to banks and do a massive withdrawal of money for emergency use.

In this case, the demand of money far outweighs the supply; the commercial banks will have to raise the interest rate to curb withdrawal. Despite the effort from the central bank, interest rate went up instead of down. In short term, prices of different classes of assets will likely reflect as below:

Asset Class Expected Reaction Likely Actual Reaction
Stock Market & Real Estate Up Down
Bond Prices Up Up
Bond Yield Down Down
Gold Up Down
Interest Rate (Federal Fund Rate) Down Up
Currency Down Up

In this scenario, increase of money supply by reducing the interest rate has failed to stimulate the economy.

Scenario 2 – Country with Loose Monetary Policy and Form Asset Bubble

With the economy is already doing very well, commercial banks are still able to lend out money at low interest rate, assets such as housing prices and stocks will appreciate to an unsustainable level and form asset bubble. The economy is overheating.

At the same time, inflation is creeping up. When the public begin to feel the pain of inflation, cut down spending and save money, and stop buying assets because they are too expensive. That’s when the bubble burst. Assets prices will start to fall as investors will start bidding down the prices to obtain cash.

Companies will start doing badly as business demand is slowing since everybody is saving cash due to inflation. Unemployment will start rising as companies begin to cut their expenses.

Commercial banks are making losses because people who took up the loan are not able to pay back the balance loan even after selling the assets, because the prices of asset have fallen. More and more people are getting bankrupt. Because of this, commercial banks will also curb lending as they are afraid of bad loans.

By then, there is little that central bank can do because monetary policy was already loose (low interest rate).

It gets worse, to improve business, companies will start to bring down prices on products and services, and economy will begin to experience deflation. With deflation, companies will have to do more job cuts to improve earnings. This brings unemployment rate even higher, bringing the economy into a downward spiral.

Scenario 3 – Sudden Increase of High Interest Rate and Slam the Overheat Economy

Let’s assume central bank realize the economy is overheating, and decide to cool it down. However, instead of increasing the interest rate slowly, the central bank hikes the interest rate at a rate that is so high that took everyone by surprise. This is like putting a jam brake on a sports car speeding on highway; the sports car can lose its control, flip and crash. Same things can happen to the economy.

When the money supply is reduced at such level which took everyone by surprise:

Business lending will drop dramatically due to high interest rate, and this slows down business investment. Less business investment mean lesser projects, and companies provide goods and services will begin to experience loses.

Currency will appreciate as there is lesser supply with the increase of interest rate. As the currency is appreciating, goods and services will appear to be more expensive to foreign countries; this will impact the export businesses of the country.

Unemployment will start rising as companies begin to cut spending to avoid losses.

Ultimately the jam brake brought down the economy to its knees.

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