The Effect of Monetary Policy on Short-Term Interest Rates

Even though theorists acquiesce to the liquidity effect as a theoietical proposition, it is often challenged on efficacy grounds. It is argued that changes in the money stock do not leave all other things unchanged. Monetarists, such as Friedman (1968) assert that the liquidity effect is, at best, only temporary; the ultimate effect of more rapid money growth is higher inflation (or, mom-c importantly, expectations of higherinflation) and, consequently, higher nominal interest rates. New classical economists argue that the real interest rate is determined by basic tastes and technology considerations, which are slow to change.’ If increases in the money supply primarily affect the market’s expectations of inflation, nominal interest rates will rise immediately.