Saturday, August 13, 2011
Why does an increase in money supply decrease nominal interest rates in the SR but increase them in the LR?
Irving Fisher demonstrated that the nominal interest is equal to the real interest rate plus the expected inflation rate. Like anything else, when the supply of money is increased, the immediate price will fall. Expected price inflation for the short term (<30 days) is near zero, but for the longer term it rises to the level of how much the money supply has been inflated. In a hyper inflation state, nobody will charge you any interest for holding currency for an hour, but will charge perhaps 100% for holding it a day.
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