Money and Income Relationship:

In this sub-section we examine further into the relationship between money, output and interest rate. As we saw earlier the link between the money and the interest rate comes through the money market. We saw above that money demand is a decreasing function of rate of interest but a rising function of level of income. 

Money supply on the other hand may or may not be a function of rate of interest depending on whether money is assumed to be endogenous or exogenous. In the classical model money is considered to be exogenous in the sense the monetary authority has complete control over it. This means it is not affected by the changes in the interest rate. In case of endogenous money, the monetary authority has no control over the money supply, and the demand for money determines the supply of money. In real world the situation is a convex combination of the two. This means money supply process is partly controlled by the monetary authority and partly by the money demand. It has been observed that the monetary authority tries to accommodate the expansion in money demand in normal circumstances. However, in the situation of high inflation (or overheating) the central bank uses its control over
the interest rate through the instruments of monetary policy available to it to stabilize the economy.