To understand the relationship between money inflation and interest rates

To understand the relationship between money

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To understand the relationship between money, inflation, and interest rates, recall the distinction between the nominal interest rate and the real interest rate. The nominal interest rate is the interest rate you hear about at your bank. If you have a savings account, for instance, the nominal interest rate tells you how fast the number of dollars in your account will rise over time. The real interest rate corrects the nominal interest rate for the effect of inflation in order to tell you how fast the purchasing power of your savings account will rise over time.Reversed Equation: Nominal Interest = Real Interest Rate + Inflation RateAccording to the quantity theory of money, growth in the money supply determines the inflation rate.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 the real interest rate not to be affected, the nominal interest rate must adjust one- for-one to changes in the inflation rate. Thus, when the Bank of Canada increases the rate of money growth, the result is both a higher inflation rate and a higher nominal interest rate. This adjustment of the nominal interest rate to the inflation rate is called the Fisher effect (-the one-for-one adjustment of the nominal interest rate to the inflation rate), after economist Irving Fisher (1867…1947), who first studied it. Fisher effect has maintained a long-run perspective. Expected inflation moves with actual inflation in the long run but not necessarily in the short run. The Fisher effect is crucial for understanding changes over time in the nominal interest rate.The Costs of InflationIn the late 1970s, when the Canadian inflation rate reached levels in excess of 10 percent per year, inflation dominated debates over economic policy. And even though inflation has remained low since the early 1990s, it remains a closely watched macroeconomic variable. Inflation is closely watched and widely discussed because it is thought to be a serious economic problem. But is that true? And if so, why?A fall in Purchasing Power? The Inflation Fallacy When prices rise, each dollar of income buys fewer goods and services. Thus, it might seem that inflation directly lowers living standards. Yet further thought reveals a fallacy in this answer. Because most people earn their incomes by selling their services, such as
their labour, inflation in incomes goes hand in hand with inflation in prices. Thus, inflation does not in itself reduce people’s real purchasing power. People believe the inflation fallacy because they do not appreciate the principle of monetary neutrality. A worker who receives an annual raise of 10 percent tends to view that raise as a reward for her own talent and effort. When an inflation rate of 6 percent reduces the real value of that raise to only 4 percent, the worker might feel that she has been cheated of what is rightfully her due. In fact, as we discussed in the chapter on

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