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An increase in the rate of inflation will leave real and nominal rates unchanged in the...

An increase in the rate of inflation will leave real and nominal rates unchanged in the long run. True or false? Use IS and LM curves to explain your answer.

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Answer #1

False

When rate of inflation is increased in the short run, nominal interest rate rises. This raises the real interest rate as well. However, in the long run, nominal interest rate declines below its original level because inflation rate increases further and the real interest rate returns to its original level. Hence in the long run only real interest rate remains unchanged. This can be shown by a rightward shift of the IS curve as a result of fiscal expansion which raises real interest as well as nominal interest rate in the short run. However, as long run approaches, inflation rises further and GDP falls so that real interest rate reduces to its original level and IS curve shifts back.

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