A monetary analysis of pre-financial crisis investor behavior: Supply of money and the nature of banking institutions

Martin Mygind

Student thesis: Master thesis


The focus in this thesis is on the relationship between interest rates and supply of money in relation to investor and consumption incentives, as the interest rate is believed to be one of the main drivers of investor behavior. The analysis is initiated with a discussion on the relationship between the supply of money and the price level, using the Quantity Theory of Money and the CPI, which in the period reviewed was characterized by a constant rise. The effect of inflation proved to impact the behavior of consumers, since the reduction of purchasing power gives incentives for consumption as opposed to saving. The aim of the increasing supply of money is a reduction in the interest rates, which are reduced as an effect of a reduction in demand for financial capital. The supply of money has its sources from an expansion of base money and from banks in terms of lending against reserves, and the difference proves to be a crucial distinction. The reduction in the interest rates increases incentives to borrow money for consumption and investment. Thus the statistics also revealed an increased level of investment in the period reviewed. The increased risk taking was also driven by the various government interventions such as the CRA, the FDIC, the GSE’s and bailouts who contributed to moral hazard behavior, directed capital to the most risky assets, and reduced corporate and investor accountability. The investments and increased risk taking were mainly driven by companies that saw a potential to expand due to increased demand and therefore more new products and services entered the market. The decreasing interest rates had reduced opportunity cost of capital and allowed for less profitable companies to rise and increase their output. This created a problem as there is a relationship between the NPV and the value of the output of products and services. Thus it is revealed that the increase in the supply of money does not add to an equal increase in terms of exchangeable value. In the distinction between the two types of money expansion, it is revealed that the increase in the supply of money from banks neutralized the price level, as the lending criteria assured that the increase in the money supply was accompanied by an equal increase in exchangeable value in the market for products and services. It is the expansion of base money that causes excess lending. This is visualized by the Equation of Exchange where the effects can be analyzed. Here it is concluded that the increase in the supply of money did not spawn an equal supply of products and that the effect hereof was an increasing price level. The overall conclusion is that the increasing supply of money gives consumers incentives to consume what they would otherwise never consume, companies incentives to produce what they would otherwise never produce, and investors to invest in assets they would otherwise never invest in.

EducationsMSc in Accounting, Strategy and Control, (Graduate Programme) Final Thesis
Publication date2010
Number of pages89