A money supply will grow in one of two ways. Naturally and by the creation of new money from a central bank.

Naturally

A money supply will grow of its own accord as money is turned over in an economy. As people earn returns on their money the money supply will grow. Mainly people earn returns on their money from interest. If you have $1,000.00 in the bank earning 3% interest per year at the end of the year your money will have grown to $1,030.00. This is how a money supply grows naturally. For the entire economy as a whole to calculate out natural money supply growth you take all the money people have earned over the year and subtract all the money people have lost. Obviously over the last few years people have lost far more money than they have made so we have had negative natural money growth.

Central Banks

A money supply will also grow when a central bank purchases assets and releases new money into the economy. Central banks can print and release as much money as they like into an economy.

How do interest rates effect this?

When interest rates are very low it becomes almost impossible for natural money supply growth to occur. If you have $1,000.00 earning .25% interest per year at the end of the year you’ll have but $1,002.50. That $2.50 will hardly cover any losses of money people experience over the year and thus you end up with at best zero natural money supply growth and probably you’d end up with negative natural money growth.

With very low interest rates the only way a money supply will grow is through central bank actions.

The best example of this has been the Japanese economy for the last two decades. Japan has had the lowest interest rates in the world over the last 20 years and very little, if any, natural money supply growth. As natural money growth has been lacking in Japan so has real economic growth. It’s just too hard to make significant gains with very low interest rates. The only real money growth in Japan over the last two decades has been from the Bank of Japan.

If Japan wants faster economic growth the Bank of Japan must Raise interest rates and allow natural money supply growth to occur. Once natural money growth occurs and people can earn better returns on their money they will spend more and take bigger risks with their money which creates faster economic growth.

The idea that low interest rates can cause inflation is simply wrong. Low interest rates prevent natural money growth from occurring. Japan has had the lowest interest rates on the planet for over two decades and just about the lowest inflation rates on the planet for two decades. If low interest rates caused inflation Japan would have had roaring inflation for the last two decades. Conversely economies with high interest rates will almost always have high inflation rates because high interest rates allows very high natural money supply growth. If you have $1,000.00 earning 15% interest you will have $1,150.00 at the end of the year. That much interest will almost always cover any money losses people incur over the course of a year.

With very low interest rates natural money supply growth will not occur. Without natural money supply growth people will not take risks with their money and economic growth stagnates unless a central bank continuously pours in new money.

Extremely low interest rates not only do not cause inflation they cause natural money growth to be nonexistent which prevents any type of rapid economic growth from occurring.  

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