Question

If the liquidity effect is smaller than the other effects, and the adjustment to expected inflation is slow, then the

A) Interest rate will fall

B)Interest rate will rise

C) Interest rate will fall immediately below the initial level when the money supply grows

**The correct answer is C but if you could explain why it is that would be very helpful. Thanks!

Answer 1

Liquidity effect refers to a fall in nominal interest rates following an exogenous persistent increase in narrow measures of the money supply. A persistent increase in the money supply both reduces nominal interest rates and
increases expected inflation so that the real rate is nominal minus expected inflation also falls.

So interest rate will initially fall but eventually climb above the initial level in response to an increase in money growth and if the adjustment to expected inflation is immediate, then the interest rate will rise immediately above the initial level when the money supply grows.

When there is a lot of money in the system, interest rates go down,then prices of bonds rise, giving the bondholders a profit.Selling bonds,that sale enter the monetary system as money in circulation or money in accounts at banks and brokerage firms.

This increases the amount of money in the system and works to further lower interest rates. Low interest rates also attract business and personal borrowing because the cost of borrowing money is less expensive. Businesses borrow to finance new plant and equipment, new hires and expanded inventory. Individuals borrow to finance purchases of homes, cars, appliances, clothing and vacations. Business expansion and increased consumer purchases results in more business activity, which in turn results in more employment.