Question

According to the liquidity preference model, increasing money supply will lead to a lower nominal interest...

According to the liquidity preference model, increasing money supply will lead to a lower nominal interest rate. But according to the quantity theory (Fisher effect), it will lead to a higher nominal interest rate. Can you explain?

Homework Answers

Answer #1

Answer) According to liquidity preference, increase in money supply leads to excess supply of money which people use to purchase bonds which increases the demand for bonds, prices rises and due to inverse relation between price and interest rate, interest rate declines.

According to Quantity theory,MV =PY , increase in money supply leads to increase in price level and hence inflation. Fischer effect = real rate of interest = nominal interest rate - inflation so to keep the real interest rate, nominal interest rate should be increased.

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