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How does a decrease in expected inflation affect output and interest rates in the IS-LM model?...

How does a decrease in expected inflation affect output and interest rates in the IS-LM model? Explain. Does the Fisher effect hold in this context? Explain.

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Answer #1

The decrease in the expected rate of inflation shifts the LM curve to the left. It implies 'r' increases and 'Y' decreases. This can be shown in the following figure.

In the above figure, LM curve shifts back to LM1 and rate of interest rose to r1 and output falls from Y to Y1. If nominal rte of interest remind constant, a decrease in the expected rate of inflation has risen the real rate of Interest.

The fishers effect shows that the real interest rate is equal to nominal interest rate minus expected rate of inflation. Fishers effect reveals the relationship between inflation and interest rates ( both nominal and real interest rates). So that in this context fishers equation existed.

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