Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Monetary policy doesn’t affect saving and investment

Whether you’re looking at an individual economy or the world economy as a whole, in the long run, the supply of savings and the demand for investment in the market for loanable funds are unaffected by monetary policy. You can see this because savings is equal to (see Chapter 9):

Savings is what’s left over from output after taking away consumption and government spending. In the long run, output is independent of monetary policy and equals its natural level . Consumption is a function of disposable

income (Y – T), which is also independent of monetary policy, , and

taxes are set by the government, . Equally, government spending is

independent of monetary policy, .

Similarly, the demand for capital goods/investment is a function of the real interest rate (r). This rate is determined by equilibrium in the loanable funds market (the domestic loanable funds market for a closed

economy and the global loanable funds market for an open economy). And because monetary policy affects neither savings nor investment in the long run, the real long-run interest rate is also independent of monetary policy.


The nominal interest rate in the long run

The preceding section shows that the real interest rate is independent of monetary policy in the long run. In this section, you see that increasing the growth rate of the money supply does have a one-for-one impact on the nominal interest rate. Understanding these two phenomena is key to understanding the Fisher effect: in the long run, expansionary monetary policy only increases inflation and the nominal interest rate; it has no effect on the real interest rate or output.

We start with the quantity equation:

where M is the stock of money, V is the velocity of circulation (how fast money travels around the economy), P is the price level and Y is output. We can easily convert that into growth rates (see Chapter 5):

Assuming that the velocity of circulation doesn’t grow over time (g_Y = 0), and

noticing that inflation is by definition the growth rate of prices ( ), yields:

Rearranging for inflation gives:

So the rate of inflation is equal to the growth of the money supply minus the growth rate of output. Note that in the long run output growth is independent of monetary policy (as we discuss in Chapter 8), because technological progress drives increases in living standards. A reasonable assumption is that technological progress is independent of monetary policy, which means that g_Y is independent of monetary policy. Thus, increasing the growth of the money supply increases inflation one-for-

one:

where is the ‘natural’ growth rate of output in the long run.

In the long run, changes in the growth rate of the money supply (g_M) have no effect on the real interest rate (r). They do, however, increase inflation (π) one-for-one: that is, an increase in g_M by one percentage point increases inflation by one percentage point. Using the Fisher equation you can see that inflation rising by one percentage point means a one-percentage-point increase in the nominal interest rate (i):

where is the real interest rate determined in the market for loanable funds. Thus, in the long run, increasing the growth rate of the money supply increases inflation one-for-one, which increases the nominal interest rate one-for-one!