Introduction
The money effect is defined as the influence of money on a countrys economic growth, or it can be defined as the influence of money supply and demand on prices, income and employment in an economy. The money effect can be broadly broken down into two distinct categories, the interest rate effect and the wealth effect. This article will explain both these effects in detail.
Interest rate effect
The interest rate effect relates to how a change in the money supply, or availability of money, influences the interest rate. When the money supply increases, there is an increase in the supply of loanable funds, which will result in the interest rate decreasing, as lenders will have more money to lend out, and there is competition for this money between borrowers. The opposite is also true, and if there is a decrease in the money supply, the interest rate will rise, as there is less loanable funds available to lenders.
Furthermore, changes in interest rates can have an effect on investment and consumer expenditure, which affect the overall economic growth of a country. Low interest rates will encourage consumer spending, and businesses to invest, because they can borrow at a lower cost. This will result in an increase in economic growth due to an increase in consumer demand, and an increase in business investment.
Wealth effect
The wealth effect is related to the increase in consumer expenditure due to a rise in household wealth. Household wealth is made up of various assets such as stocks, bonds and real estate. A rise in household wealth, or increased wealth inequality, will lead to an increase in consumer expenditure, as people will feel more secure, and therefore more willing to buy goods and services.
However, it is important to consider the wealth effect in relation to the other effects that can have an impact on an economy, and to keep in mind that an increase in consumer expenditure may not necessarily lead to an increase in economic growth, as businesses may not benefit as much from increased consumer expenditure.
Conclusion
The effects of money on an economy are complex, and can be broken down into two distinct categories; the interest rate effect and the wealth effect. The interest rate effect describes how changes in the money supply can affect interest rates, and in turn the investment and consumer expenditure which will have an effect on the overall economic growth of a country. The wealth effect is related to an increase in consumer expenditure due to a rise in household wealth, and it is important to consider all the factors that could affect an economy before relying solely on the wealth effect to increase economic growth.
