Suppose the money supply grows at an annual rate of 10%, real GDP grows at 4%, the growth rate of velocity is 0%, and the expected real interest rate on Aaa corporate bonds averages 5.5%
Use the Fisher equation to determine the nominal interest rate on Aaa bonds. What will happen to the nominal interest rate in the long run if the growth rate of the money supply decreases to 7%?
The inflation rate = 10% - 4% = 6%.
The nominal interest rate = 5.5% + 6% = 11.5%.
When the growth rate of the money supply decreases by (10% - 7%) = 3%, the inflation rate will also decrease by 3%. The decrease in the inflation rate of 3% should decrease the nominal interest rate by 3%, so in the long run, the nominal interest rate will equal 11.5% - 3% = 8.5%.
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