What is the relationship between the money supply and interest rates?

The relationship between the money supply and interest rates is fundamentally tied to the basic principles of supply and demand in the economy. When an expansion of the money supply occurs, it typically leads to lower interest rates. This is because, as more money is available in the economy, banks have more funds to lend. Consequently, the increased availability of funds generally drives down the cost of borrowing, which is reflected in lower interest rates.

Conversely, when the money supply is contracted, there is less money available for lending. This scarcity pushes the cost of borrowing—interest rates—up, as banks can afford to lend out less money and will charge a premium for the limited funds available. Therefore, the greater the contraction of the money supply, the higher the interest rates tend to rise as borrowers compete for a dwindling resource.

In a scenario where the money supply is frozen, this stability results in unchanged interest rates, as there is neither an increase in available funds nor a decrease. However, if the money supply were to contract significantly, it would lead to an increase in interest rates as lenders tighten their standards and compete more heavily for borrowers.

Thus, the correct understanding is that an expansion of the money supply correlates with lower interest rates, making the response that