The Fisher effect and the cost of unexpected inflation Suppose the nominal interest rate on car loans is 11% per year. If borrowers and lenders expect an inflation rate of 2% per year, the expected real interest rate is per year. Suppose the Fed unexpectedly increases the growth rate of the money supply, causing the inflation rate to rise unexpectedly from 2% to 6% per year. In the short run, the real interest rate on car loans will to 5% per year. The unanticipated change in inflation arbitrarily benefits . Now consider the long-run impact of the change in money growth and inflation. According to the Fisher effect, as expectations adjust to the new, higher inflation rate, the nominal interest rate will to 9% per year.

Suppose the nominal interest rate on car loans is 11% per year. If borrowers and lenders expect an inflation rate of 2% per year, the expected real interest rate is 9% per year. REAL INTEREST RATE = NOMINAL INTEREST RATE - INFLATION RATE

Suppose the Fed unexpectedly increases the growth rate of the money supply, causing the inflation rate to rise unexpectedly from 2% to 6% per year. In the short run, the real interest rate on car loans will  DECREASE to 5% per year.

The unanticipated change in inflation arbitrarily benefits BORROWERS (AND HURT LENDERS).

Now consider the long-run impact of the change in money growth and inflation. According to the Fisher effect, as expectations adjust to the new, higher inflation rate, the nominal interest rate will INCREASE TO 15% SO THE REAL INTEREST RATE IS EQUAL to 9% per year.

Explanation:

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