Question

An economy has the following money demand function: (M/P)d = (1/3)Y/i. Suppose the announcement of a new head of the central bank, with a reputation as a tough inflation fighter, reduces expected inflation by 2 percentage points. According to the Fisher effect, what is the new nominal interest rate?

Answer 1

r - 2%

Step-by-step explanation:

Nominal Interest rate = real interest rate plus expected inflation rate

that is,

Nominal Interest rate = real interest rate + expected inflation rate

let the real interest rate be r

since inflation is reduced, expected inflation rate is in the negative that is - 2%

therefore,

Nominal Interest rate = r + (- 2%)

= r - 2%