The Effect of Interest on the Money Supply, Demand and Growth

Abstract

This chapter explains why we are not only forced to grow from a microeconomic (supply side) point of view, as explained in the previous chapter, but why from a macroeconomic perspective (demand side) our monetary system makes economic growth possible. In this context we will explain why interest rates follow a downward trend in the long run and why central banks are really trend followers, not trend setters.

Full text

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Chapter 5
The Effect ofInterest ontheMoney
Supply, Demand andGrowth
5.1 Interest Makes Growth Possible (Macroeconomic View)
On one hand, interest creates a requirement to grow, but on the other it also helps
make that growth possible. To understand this point, we need to examine the
effect that the interest rate has on the money supply and demand. Here a com-
pletely new view will be offered, contrary to conventional monetary theory. I
would even go so far as to say that—at least in the long run—it is the opposite of
what is normally taught. This misunderstanding could be an important contribut-
ing factor to the problems inherent in our monetary system being not yet broadly
recognized.
According to conventional wisdom lowering interest rates fosters economic
growth and vice versa. However, the following paragraphs will show that only in the
very rst moment lowering interest rates can foster economic growth while increas-
ing interest rates can slow it down. In the medium and long run the effect of the
interest rate on the money supply works the other way around and we see a clear
positive correlation between interest rates, ination, and GDP growth rate, when
looking at the history (Fig.5.1) of the US economy (for other economies see Lee &
Werner, 2018): the higher the interest rate, the higher ination and the GDP growth
rate. That the interest rate and the growth of the money supply are necessarily posi-
tively correlated can be understood from three perspectives, which will be dis-
cussed in the next paragraph.
© The Author(s), under exclusive license to Springer Nature
Switzerland AG 2023
F. Fuders, How to Full the UN Sustainability Goals,
https://doi.org/10.1007/978-3-031-37768-6_5

60
Fig. 5.1 Interest rate, ination and GDP growth rate (US). Blue: market yield on 10-Year Treasury
Constant Maturity Rate; black: Consumer Price Index (% change from year ago); red: GDP growth
(% change from year ago). (Source: Own work. Data provided by Board of Governors of the
Federal Reserve System, US Bureau of Economic Analysis and OECD (2023). Retrieved from
Federal Reserve Bank of St. Louis (https://fred.stlouisfed.org))
5.2 Explanation oftheRelationship Between Interest, GDP
Growth andInation
5.2.1 First Perspective: Interest Makes Deposits Grow
As outlined above, interest makes deposits grow. The higher the interest rate, the
faster deposits grow and therefore the higher will be the total money supply (com-
posed of cash plus deposits). This effect might be called “interest money creation”
(Fuders, 2011; Fuders etal., 2013). The role of the interest rate in the exponential
growth of the money supply can be seen in the US (Fig. 4.2) as well as virtually any
other country. A higher money supply means more monetary units circulating and,
as more money is spent, aggregate demand grows. In other words, the interest rate
not only pushes producers to maintain or increase prots, but it also makes eco-
nomic growth possible by increasing the money supply and aggregate demand.
Here, it is crucial to understand that (i) as long as bank accounts earn interest the
money supply will grow and (ii) once interest has led to the creating of monetary
units, those units cannot be destroyed unless there is a ‘reset’ of the whole nancial
system. Money supply thus always grows when there is a positive interest rate.
The higher the interest rate, the faster the money supply will grow. And as explained
above interest makes deposits grow exponentially. This is true even for a very low
interest rate since any positive interest rate will eventually lead to the amount of the
original deposit doubling. And everything that experiences periodic doubling grows
5 The Effect ofInterest ontheMoney Supply, Demand andGrowth

61
exponentially. The difference between higher and lower interest rates is simply that
the at part of the exponential growth curve is longer for lower interest rates. This
also means that, from the moment the interest rate falls, the money supply curve
ceteris paribus will show a disruption but will eventually start to again grow expo-
nentially from that point on (dashed line in Fig. 5.2). Only a zero-interest-
environment would create a stable money supply over the long term, as shown on
the right-hand graph of Fig.5.2, which depicts the growth of the money supply with
positive interest rate until the interest falls to zero % (dashed line).
One might wonder why then the US money supply in Fig. 4.2 does not show such
a disruption. Even though the interest rate has fallen sharply since 2009 the money
supply has kept growing exponentially. Well, this is why I used the term ceteris
paribus (“all other things being equal”). It is necessary to emphasize the ceteris-
paribus constraint here, since of course money supply (cash plus deposits) also
grows via central bank money printing. And this is precisely what the Fed and other
central banks in the industrialized world have done since interest rates fell sharply
in the aftermath of the 2008 nancial crisis. The Fed has increased the monetary
base since 2009. Figure5.3 contrasts the US money supply M3 (which was depicted
already in Fig. 4.2) with the US monetary base M0, i.e., the money directly pro-
duced by the central bank. As we can see, since 2009, the central bank has signi-
cantly expanded the monetary base in an environment of falling interest rates, thus
compensating for the decreased interest-money-creation effect.
Already at this time the former chairman of the Fed Ben Bernanke was referred
to as “helicopter Ben”, for his policy of metaphorically letting money rain on the
economy from a helicopter. In 2020 when interest rates had once again fallen to near
zero and thus almost no money creation effect was occurring via interest, the Fed
did what it never before had done in its history: it increased the monetary base from
3.2 to 6 trillion USD in just 1year. The reason why we did not observe the disrup-
tion in money creation as depicted in Fig. 5.2which would normally be caused by
Fig. 5.2 Scheme money supply growth. Left: effect of lowering interest rates (but maintaining
>0); right: effect of lowering interest rates to 0%. (Source: On work)
5.2 Explanation oftheRelationship Between Interest, GDP Growth andInation

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mathematical logic of interest. This dynamic exerts a constant pressure on the econ-
omy to grow at least at the same rate. In other words, regardless of whether or not
natural resources are freely accessible goods, they will be overexploited in the long
term because of this logic of growth.The next Chap. 6 discusses the connection
between economic growth and the degradation of our natural environmentin greater
detail.
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