Now that we have seen how the interest rate is determined, we can use the theory of liquidity preference to show how the interest rate responds to changes in the supply of money. Suppose, for instance, that the Fed suddenly decreases the money supply:

$M$

3.50
2.55.5

A fall in $M$ reduces $\frac{M}{P}$ because $P$ is fixed in the model. The supply of real money balances shifts to the left. The equilibrium interest rate rises and the higher interest rate makes people satisfied to hold the smaller quantity of real money balances. The opposite would occur if the Fed had suddenly increased the money supply. Thus, according to the theory of liquidity preference, a decrease in the money supply raises the interest rate, and an increase in the money supply lowers the interest rate.