Question

Under the assumptions of the Fisher effect and monetary neutrality, if the money supply growth rate rises, then
a. the nominal interest rate rises, but the real interest rate does not.
b. the real interest rate rises, but the nominal interest rate does not.
c. neither the nominal nor the real interest rate rise.
d. both the nominal and the real interest rate rise.

Answer 1

Under the assumptions of the Fisher effect and monetary neutrality, if the money supply growth rate rises, the correct answer is:

**a. the nominal interest rate rises, but the real interest rate does not.**

Here's the reasoning:

1. **Fisher Effect**: The Fisher effect implies that the nominal interest rate is equal to the real interest rate plus the expected inflation rate. Therefore, if money supply growth increases, it typically leads to higher inflation expectations.

2. **Monetary Neutrality**: This assumes that changes in the money supply do not affect real variables in the long run; hence the real interest rate remains constant.

So, when the money supply grows, this would cause an increase in expected inflation, leading to an increase in the nominal interest rate while the real interest rate remains unchanged.