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

Reeling in the Fisher Effect

Like most things in macroeconomics, monetary policy has a different impact in the short run and the long run. In the short run monetary policy has real effects: it changes the level of real GDP and unemployment. However in the long run monetary policy has no real effects. The Fisher effect (explained in this section) makes this clear.

The Fisher effect says that in the long run an increase in the growth rate of the money supply by one percentage point leads to a one-percentage-point increase in the nominal interest rate and the inflation rate. However, it has no effect on the real interest rate or the growth rate of output.

Quite a lot is going on in that paragraph, but by a great stroke of luck we devote this section to making sense of it!

Discovering the real interest rate in the long run

The real interest rate in the long run is determined by the market for loanable funds, which is where savers meet investors: more precisely, it’s where people with excess money lend to those with investment projects that need financing. Of course, savers and investors don’t usually meet each other directly – the financial system acts as a convenient intermediary between them.


Saving and investment in a closed economy


An intimate link exists between the amount of savings (S) and investment (I) in an economy. In fact, in a closed economy (one that doesn’t trade with the rest of the world), they must be exactly equal to each other (Chapter 9 explains why):

This expression is quite peculiar when you think about it. Why should the total amount of savings in a country exactly equal the new capital stock being purchased that year? What ensures that they’re equal? The answer is the interest rate, which is the price that adjusts to ensure that the amount people want to save is exactly equal to the amount people want to invest.

In Figure 10-7, I(r) is investment that’s a function of the real interest rate: the lower r, the more investment firms want to undertake. I(r) also represents the demand for loanable funds. The vertical line S is savings, that is, what’s left over from output after consumption and government spending (Y – C – G). S also represents the supply of loanable funds. The interest rate adjusts to ensure that the demand for loanable funds is exactly equal to the supply of loanable funds.

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Figure 10-7: Market for loanable funds.