Month: August 2022

Goods market and money market equilibrium implies that we achieve equilibrium E where money supply is M/p₀ and real and nominal interest rates are equal to each other at i₀ = r₀. We can now trace out the consequences of an exogenous increase in inflationary expectations. By raising inflationary expectations to some positive amount, p e > 0, the MM curves shifts down to MM( p e >0). The new equilibrium rate of real interest, r_{step one}, is at point F in Figure 13, where MM( p e >0) and YY intersect. However, as now i = r + p e , then a “wedge” of size p e is created between the old MM curve and the new one: the new real rate r₁ is read off the intersection of YY and the new MM curve (point F) and the new nominal rate i₁ is read off the top curve MM( p e =0) at the same level of money supply (point G). Obviously, then, the introduction of inflationary expectations has increased the nominal interest rate from i₀ to i₁, but the amount of the increase is less than the full amount of expectations, p e . In other words, the real rate of interest has fallen by less than the full amount of inflationary expectations. Thus, Fisher’s Law of nominal interest rates adjusting to inflationary expectations one-for-one is disabled.

A higher expected rate of inflation drove up the nominal rate. Consequently, agents attempted to get rid of their excess money holdings by bidding up the price of equity and thus drove the real rate of return on equity down. This collapse in the real rate of return will induce more investment, but as we are at a fixed level of output, then consequently something else must give way to keep aggregate demand constant – namely, consumption. Continue reading “Suppose, today, one to inflationary standard was zero, p elizabeth = 0, and so the MM( p e = 0) bend is applicable”