640 PART TEN MONEY AND PRICES IN THE LONG RUN For example, if the bank posts a nominal interest rate of 7 percent per year and the inflation rate is 3 percent per year, then the real value of the deposits grows by 4 percent per year. We can rewrite this equation to show that the nominal interest rate is the sum of the real interest rate and the inflation rate: Nominal interest rate ± Real interest rate ² Inflation rate. This way of looking at the nominal interest rate is useful because different eco-nomic forces determine each of the two terms on the right-hand side of this equa-tion. As we discussed in Chapter 25, the supply and demand for loanable funds determine the real interest rate. And, according to the quantity theory of money, growth in the money supply determines the inflation rate. Let’s now consider how the growth in the money supply affects interest rates. In the long run over which money is neutral, a change in money growth should not affect the real interest rate. The real interest rate is, after all, a real variable. For
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This note was uploaded on 07/30/2010 for the course ECON 120 taught by Professor Abijian during the Spring '10 term at Mesa CC.