Question

According to the theory of liquidity preference, decreasing the money supply will ______ nominal interest rates in the short run, and, according to the Fisher effect, decreasing the money supply will ______ nominal interest rates in the long run.

Answer 1

Answer: (1) Increase

(2) Decrease

Step-by-step explanation:

According to the theory of liquidity preference, if there is a tightening of money supply then as a result consumer are having less cash in their hands, there is increase in the money demand for transaction purposes which will rise the nominal interest rate in the short run.

Whereas according to the fisher effect, decrease in the money supply will result in lower nominal interest rate in the long run. According to fisher, Inflation and nominal interest rate moves in the same direction. Here, decrease in money supply means that there is fall in the inflation rate as a result nominal interest rate also falls.