I learned from the Fischer Effect that

Real Interest Rate = Nominal Interest Rate - Inflation Rate .

But in today's class the professor told us that due to money neutrality, an increase in money growth doesn't affect the real interest rate, just nominal interest rate.

The reason this is confusing to me is that when money growth increases the nominal interest rate decreases.

so it definitely affects the real interest rate.

I'm aware that this is the short-run affect. Nominal interest (decrease) - Inflation rate (increase) = Real interest Rate (decrease)

So why, in the long run, doesn't real interest rate change? Why is nominal interest rate the only variable affected?

Everyone's been answering "its because money neutrality applies to the long-run". I don't really like this answer because it still doesn't explain why money growth doesn't affect "real interest rate" out of all real variables.

So my question is this: Why does the increase in money supple not affect real interest rate? Could someone explain this in an economic context, containing the behavior of agents, not in some kind of mathematical way like "its because of money neutrality" which has no economic logic to explaining why money supply doesn't affect Real Interest Rate in the long run .

  • $\begingroup$ The issue is your statement "when money growth increases the nominal interest rate decreases". This may sometimes be true (either an increase in supply might reduce the price, or the causality is reversed with a nominal interest rate reduction designed to increase demand for money) or sometimes false (an increase in the money supply might lead to inflation and either central banks raise interest rates to choke this or creditors demand compensation by insisting on higher interest rates). Monetary neutrality would claim, at least over the medium term, that your statement is false $\endgroup$ – Henry Dec 16 '17 at 17:47

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.