What happens during a decrease in money supply?

A decrease in the money supply typically leads to an increase in interest rates. When the amount of money available in the economy decreases, borrowing becomes more expensive because lenders will charge higher rates to compensate for the reduced liquidity. As a result, the cost of loans rises, which can dampen consumer spending and business investment. Higher interest rates discourage borrowing, which can lead to slower economic growth and reduced inflation pressures.

In this context, while inflation rates may not necessarily rise and government spending is not typically affected directly by changes in the money supply in the short term, the relationship between the money supply and interest rates is well-established in economic theory. Reductions in the money supply create less available credit, leading to a tightening of financial conditions reflected in rising interest rates. This sequence of events helps to solidify the role of interest rates as a key mechanism through which monetary policy operates.