The relationship between money supply and the rate of interest

Simple monetary theory often assumes that the supply of money is totally independent of interest rates. The money supply is 'exogenous'. The supply of money is assumed to be determined by government: what the government chooses it to be, or what it allows it to be by its choices of the level and method of financing the PSNCR.

Some economists, however, argue that money supply is 'endogenous', with higher interest rates leading to increase in the supply of money. The argument is that the supply of money is responding to the demand for money. If people start borrowing more money, the resulting shortage of money in bank will drive interest rates. But if banks have surplus liquidity or are prepared to operate with a lower liquidity ratio, they will create extra credit in response to the increased demand and higher interest rates: money supply has expanded.