Question

Suppose you are told that there has been a change in the nominal interest rate and this was preceded by a change in money supply, would you assume you were in the short run or long run? Explain.

Answer 1

If the change in money supply is changing the real interest rate by changing inflation, then it is considered a short run case because real rate of interest is not influenced by money supply in the long run. This uses Fisher's effect because inflation reduces real interest rate if nominal interest rate is unchanged. However, nominal rate of interest can change in the long run when inflation is increased in same proportion so that real interest rate remains same.

Hence if money supply is changed, we expect inflation to reflect the change and so nominal change is also changed. This keeps real interest rate as it as and thus, we are in the long run.