The responsiveness of the money supply to changes in income is called reverse causation . This effect of economic activity and the actions of economic participants on the money supply is part of reverse causation, where the demand for money determines the supply of money. As income increases, the money demand function also increases, from M d0 to M d1 . This situation occurs during an expansion when income is increasing. Economic participants need more money to support more and bigger purchases.
Many economic participants borrow to increase their money balances.
If the banks have excess reserves, they can easily make new loans and expand the money supply from M s0 to M s1 . Even if the banks are fully loaned up, they can obtain additional reserves by selling T-bills, by issuing bank deposit notes, by conducting repurchase agreements with their depositors, or by borrowing in the eurodollar market or at the discount window. With these new reserves,the banks can further expand the money supply. As income decreases, the money demand function also decreases, from M d0 to M d2 . This situation occurs during an contraction when income is decreasing.