INFLATIONARY EXPECTATIONS, MONEY GROWTH, AND THE VANISHING LIQUIDITY EFFECT OF MONEY ON INTEREST: A FURTHER INVESTIGATION

An important issue in discussion of the transmis- sion mechanism of monetary policy is the response pattern of nominal interest rates to changes in the growth rate of money. The traditional analysis of the effects of changes in money growth on nominal interest rates runs in terms of liquidity, income, and expectations effects.l Consider an increase in the growth rate of money. Initially, there is an excess supply of money at the existing income, interest rate, and the price level. If the price level and real income adjust slowly, then the nominal interest rate must decline in order to equate money demand and money supply. This initial fall in the nominal and real2 interest rates is known as the liquidity effect. Over time, nominal income will rise following the increased growth rate of money and this rise in nominal income will increase money demand which in turn leads to higher interest rates. This is the income effect of money on the nominal interest rate. Finally, there is a Fisher or expectations effect as nominal interest rates increase due to a rise in inflationary expecta- tions induced by the higher money growth rate.