We assume that when the growth in the money supply increases, interest rates should go down. But schweser says that , it leads to increased actual inflation, expected inflation and nominal interest rate. They seem to be right. Does it mean that in the short term interest rates go down and then bcoz of inflation come up again?
Smeet, I think increasing money supply does reduce nominal rates and increase inflation. I think it’s an empirical question whether the two effects cancel eachother so that real rates remain constant. To increase money supply, the fed could buy treasury securities and thus put money in the buyer’s hands. The increased demand for the treasury securities would increase treasury prices and decrease yields (hence interest rates). Recalling the equation MV = PY, the higher amount of money in the economy could result in higher prices (inflation), lower velocity or higher output. Which of these effects the higher money supply has I think would depend in part on the level of output of the economy (i.e., if already producing at full capacity, increased money supply leads to inflation only, but if producing less than full capacity, could help output get back to equilibrium).
Ok Thanks a lot for the explanation. Another question was regarding long term and short term movements. Do we say short term when demand moves and long term is after the supply evaluates the situation and move accordingly ( whether its an expansion or recession) ?
I was re re reading the post and you mentioned real interest rate will remain constant. However real = nominal - inflation. If inflation increases and nominal decreases, wont real decrease?
I think that’s a fair way to look at things. Similarly, long-term on the Phillips curve is after people have revised their expectations and had a chance to shift the curve (as compared to being moved along the existing curve when they are surprised).
You’re right Smeet, silly me. I think the basic rule is greater money supply, lower interest rates & higher inflation. Maybe the Schweser statement about nominal rates increasing is based on people getting worried about the higher inflation and thus tacking on a significant inflation premium to the real interest rate, causing nominal rates to rise even though real rates have fallen.