# Explanation for Mundell-Tobin Effect

Apparently, Mundell and Tobin used different methods to explain the Mundell-Tobin effect (which means that in general higher inflation increases the nominal interest rate, but decreases the real interest rate so Fisher's statement about the one-for-one adjustment of the nominal interest rate to the increase in inflation is slightly wrong) and I have two questions regarding their arguments:

1. According to Mundell, higher inflation reduces demand for money and increases demand for Bonds, decreasing the required return on bonds and decreasing the real interest rate.

Question here: Aren't required return on bonds "nominal"? So I assume here that the decrease in the required return for bonds means a decrease in the "nominal" interest rate. But isn't the Mundell-Tobin effect supposed to result in 'higher' nominal interest rates? This looks likes a contradiction to me but obviously I'm pretty sure I'm misunderstanding something here so I wish to know what I'm missing.

1. According to Tobin, higher inflation reduces demand for money and increases demand for real capital, decreasing the marginal productivity of capital and decreasing the real interest rate.

Question here: I believe that an increase in the demand for real capital means the same thing as the increase in the demand for loanable funds to acquire capital as investment(in the loanable funds market). In this case the rightward shift of the demand curve for lonable funds actually increases the real interest rate in the loanable funds market, which directly contradicts Tobin's statement (since it is the real interest rate that is associated with the loanable funds market, not the nominal interest rate). So how should I understand this contradiction?

Robert Mundell originally wrote about Mundell-Tobin effect in response to the Fisher effect, which states that "the real interest rate is unaffected by monetary policy and hence unaffected by the expected inflation rate." In other words, nominal interest rates will always adjust such that real interest rates stay at whatever the market rate is. Hence, if inflation rises, then nominal interest rates must rise. Which brings us to the first point of confusion...

Mundell-Tobin effect supposed to result in 'higher' nominal interest rates

This is the Fisher effect not Mundell-Tobin. Note the Mundell-Tobin effect explains why nominal interest rates will not rise as high as expected by the Fisher effect - it will be less than one-to-one. This is not a contradiction as much as a competing factor.

I believe that an increase in the demand for real capital means the same thing as the increase in the demand for loanable funds

The reduced demand for money increases the supply of loanable funds, which induces more demand, which is then used to purchase real capital. This in turn reduces the expected rate of return on this capital. If expected rate of return is not as high on capital, real interest rates do not have to be as high to compete in terms of opportunity cost.

• do you mean that the reduction in the bond return (nominal interest rate) is a way of explaining that the nominal interest rate will not rise 100% one-to-one in response to the rise in expected inflation? Because of the downward pressure of the bond yield due to the increase in the demand for bonds? Sep 7, 2019 at 5:37
• Indeed because of the downward pressure on bond yields. Sep 7, 2019 at 8:04

The Mundell-Tobin effect is only significant if there are a lot of people holding cash.

1. Inflation causes the value of cash to decrease in real terms. When inflation is high, the required rate of return of bonds in real terms does not have to be so high for it to be worthwhile to move cash into bonds.

2. If all capital assets are bought with loans, then demand for capital assets will be unaffected by inflation. However, capital assets may also be bought with cash.

The following blog post explains the Mundell-Tobin effect better than I can. http://illusionofprosperity.blogspot.com/2011/01/mundell-tobin-effect-epiphany.html