THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 139

CHAPTER 5

The Behaviour of Interest Rates

107

Interest Rate, i

i1
i2
T

(a) Liquidity effect larger than
other effects

Liquidity Income, Price-Level,
and ExpectedEffect
Inflation Effects

Time

Interest Rate, i

i2
i1
(b) Liquidity effect smaller than
other effects and slow adjustment
of expected inflation

T
Liquidity Income, Price-Level,

and ExpectedEffect
Inflation Effects

Time

Interest Rate, i

i2
i1
(c) Liquidity effect smaller than
expected-inflation effect and fast
adjustment of expected inflation

T
Income and PriceLiquidity and
Level Effects
ExpectedInflation Effects

F I G U R E 5 - 12

Time

Response over Time to an Increase in Money Supply Growth

Panel (b) has a smaller liquidity effect than the other effects, with the expectedinflation effect operating slowly because expectations of inflation are slow to
adjust upward. Initially, the liquidity effect drives down the interest rate. Then the
income, price-level, and expected-inflation effects begin to raise it. Because these
effects are dominant, the interest rate eventually rises above its initial level to i2.
In the short run, lower interest rates result from increased money growth, but
eventually they end up climbing above the initial level.

Panel (c) has the expected-inflation effect dominating as well as operating
rapidly because people quickly raise their expectations of inflation when the rate of