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How the supply of money affects the economy?

If the Government reduces the supply of money, banks and money lenders will find they have less money to lend to people and firms. This shortage of the supply of money will lead them to charge higher interest rate. Moreover, in order to obtain more money they will increase the interest rates to attract savers to put money in deposit accounts. All these actions will lead to lowering the aggregate demand and the prices will come down.

On the other hand, if the Government increases the supply of money to banks, they will lower the interest rates in order to encourage people and firms to borrow more. More individuals and firms will borrow thus boosting the aggregate demand and the output of the economy. But if the increase in supply is not calculated properly it can result in inflation.

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