When other variables are constant, the increase of money supply will lead to the decrease of interest rate and the increase of price, which was put forward by liquidity preference theory and called by Friedman as liquidity effect. But Friedman believes that in reality, when the money supply rises, interest rates do not necessarily fall (prices do not necessarily rise), because changes in the money supply will have an impact on other variables, specifically, there are three kinds of effects:
1. Price effect: According to liquidity preference theory, rising prices lead to rising demand for money and rising interest rates?
2. Income effect: According to liquidity preference theory, rising income leads to rising demand for money and rising interest rates;
3. Inflation expectation effect: Rising prices will lead to inflation, which will also affect people's expectations of inflation. According to the theory of bond supply and demand, inflation is expected to rise. As the expected price of tangible assets rises, the expected rate of return of tangible assets will rise, and the relative expected rate of return of bonds will fall. As a result, the demand for bonds fell, bond prices fell and interest rates rose.
Liquidity effect and these three effects have opposite effects on interest rate, so Friedman thinks that the influence of the increase of money supply on interest rate depends on liquidity effect and the relative size of these three effects. At the same time, the playing time of these four effects will also affect the role of interest rates. Generally speaking:
Liquidity effect can generally play a direct role.
There is a time lag between price effect and income effect.
The expected effect of inflation is uncertain, which depends on the expected adjustment speed.
So in combination, there will be several situations (incomplete list) when the money supply rises.
If the inflation expectation effect is slow and the three effects (price effect, income effect and inflation expectation effect) are greater than the liquidity effect, the interest rate will fall first and then rise, and the new equilibrium interest rate will be higher than the original equilibrium interest rate.
If the inflation expectation effect is slow and the three effects (price effect, income effect and inflation expectation effect) are less than the liquidity effect, the interest rate will fall first and then rise, but the new equilibrium interest rate is lower than the original equilibrium interest rate.
If the inflation expectation effect plays fast and the inflation expectation effect is greater than the liquidity effect, the interest rate will rise first, and then continue to rise after the price effect and income effect play, and the new equilibrium interest rate is higher than the original equilibrium interest rate.
If you are interested, you can look at the final application of chapter 5 of mishkin's Monetary Finance: Money and Interest Rate, mainly the orz mentioned in this book.