Question

Why does the quantity theory, or fisher effect, show that increasing the money supply will lead to a higher nominal rate when the liquidity preference model shows that it will lead to a lower nominal interest rate?

Answer 1

SOLUTION

QUANDITY THEORY OR FISHER EFFECT

The Fisher effect is an economic theory created by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.

Fisher's equation reflects that the real interest rate can be taken by subracting the expected inflation rate from the nominal interest rates. In this equation, all the provided rates are compounded. The Fisher effect can be seen each time you go to the bank; the interest rate an investor has on savings account is really the nominal interest rates. For example, if the nominal interest rate on savings account is 4 % and the expected rate of inflation is 3 %, then the money in the savings account is really growing at 1 %. The smaller the real interest rate, the longer it will take for savings deposits to grow substantiallynn when observed from a purchasing power perspective.

Nominal interest rates reflects the financial return an individual gets when he deposits money. For example, a nominal interest rate of 10 % per year means that an individual will recieve an additional 10 % of the money deposited in the bank. Unlike the nominal interest rate, the real interest rate considers purchasing power in the equation. In the Fisher effect, the nominal interest rate is provided actual interest rate that reflects the monetary growth padded over time to a particular amount of money or currency owed to a financial lender. Real interest rate is the mirrors the purchasing power of the borrowed money as it grows over time.When the money supply increases it means that more money is available in the economy for borrowing and this increased supply, in line with the law of demand tends to reduce the interest rates, or the price for borrowing money down. Similarly when the money supply decreases, it will tend to increase the interest rates.