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Chapter 5: Q.17 (page 164)

Why should a rise in the price level (but not in expected inflation) cause interest rates to rise when the nominal money supply is fixed?

Short Answer

Expert verified

The decrease in money's purchasing power, interest rates will rise.

Step by step solution

01

Introduction

Inflation is defined as a condition in which the price of all goods and services begins to rise, reducing people's real purchasing power.

02

Explanation

If the price level rises, the purchasing power of money falls, implying that a person will have to spend more money to buy the same products. When a result of this, people wish to keep their money as the price level rises. As a result, the demand curve for money will shift to the right in this situation. The interest rate rises as you move to the right.

As a result of the decrease in money's purchasing power, interest rates will rise.

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