How does increasing the money supply stimulate economic growth?

Answer 1

First, one should keep in mind that money supply grows at some rate over time, though for solving simple economic problems it may be assumed the growth rate is zero, therefore, as a matter of simplicity one may take initial money supply level as given and in equilibrium. The supply of money is assumed to be independent of the interest rate and so in the simple model it is drawn vertically for the diagram with the nominal interest rate on the vertical axis and quantity of money balances displayed on the horisontal axis respectively.

Let me demonstrate some economis reasoning for beginners. You start with an assumption the economy is in equilibrium: basically, supply equals demand (general equilibrium assumes no excess demand across all markets in the economy but the point is not here). If one was a neoclassical economist, a proof based on maths and marginal analysis would be provided to determine supply of money and demand for money in that initial equilibrium. The equilibrium is visualised via drawing a vertical line representing the money supply (MS) and a downward sloping curve/line being the money demand (MD).

Their intersept gives values for the interest rate and quantity of money balances that make MS=MD and equilbrates the economy.

Now one asks what will happen if MS increases. Visually one shifts the MS to the right to demonstrate it and realizes that ceteris paribus (meaning eveything else being constant) money demand is not affected so the equilibrium interest rate represented by the intersection of MD and MS is now lower and quantity of money balances higher. In a simple model like this a decrease in the interest rate would stimulate investment, and investment stimulates economic growth.

So to sum up, a money supply increase reduces the interest rate (ceteris paribus), a reduction in the interest rate leads to an increase in investment, an increase in investment leads to the economic growth. Surely this is far from being the whole story but it puts some light on the problem. Any questions? :)

(EDIT by someone else) Hmm... spoken like a true politician, sir. This is a really simple answer, actually. The fact of the matter is that it doesn't stimulate economic growth, it's only supposed to keep total bankruptcy away for a limited time. Well, that's what it is supposed to be used for, anyway.