According to the natural rate hypothesis, expansionary monetary policy might temporarily reduce nominal interest rates, but in the long run, expansionary policies drive nominal interest rates up, not down. Figure 8 shows why by relating the supply and demand for loanable funds to nominal interest rates. The supply and demand for loanable funds is linked closely to the market for money discussed earlier. Changes in real interest rates will shift these supplies and demands.
Figure 8 Keynes and Fisher Effects in the Market for Real Loanable Funds
Suppose monetary policymakers view a nominal interest rate of 6 percent (at point a---the intersection of D0 and S0) as too high---they perceive it as inhibiting investment and spending. If they follow expansionary open-market operations, the supply of loanable funds initially rises to S1 and the nominal interest rate falls to 4 percent ( point b). This temporary fall in nominal interest rates caused by expansionary policies will yield even larger declines in real interest rates because natural rate theory predicts that overly expansionary policies cause inflation.
The Keynes effect predicts declines in interest rates following expansionary monetary policy, and vice versa.
If expansionary policies trigger annual inflation of 4 percent, the real rate of interest is zero. Borrowers eventually will boost real demands for funds to, say, D1 because borrowing seems so cheap---loans are repaid in depreciated dollars. Lenders will reduce supplies to S2 because they gained no real purchasing power at a zero real interest rate. In the long run, the nominal interest rate rises to 10 percent (point c in Figure 8). Irving Fisher, a prominent early American monetary theorist (see his biography) was the first to systematically addressed adjustments of this type.
The natural rate of real interest theory suggests that an expansion of the money supply may temporarily increase the supply of loanable funds and drive nominal interest rates down via the Keynes effect, but if inflation results and comes to be expected, the Fisher effect may cause nominal interest rates to rise above the inflation level. These effects operate in exactly opposite directions when contractionary policies are followed. The lesson here (paralleling that for the natural rate of unemployment) is that policymakers' attempts to artificially reduce interest rates are ultimately doomed to failure.
Expansionary money policies in 1978 drove real interest rates down via the Keynes effect as inflation exceeded nominal interest in 1979. Nominal interest rates rose to compensate for unexpected inflation in 1980--1981, even though inflation was falling; this was the Fisher effect in action.
Sources: Moody's Bond Record, Business Conditions Digest, and Economic Reports of the President, various issues.
The Fisher effect predicts upward adjustments in nominal interest rates as borrowers and lenders compensate for expected inflation, and downward shifts if deflation is expected.
Contractionary monetary policies tend to reduce the availability of credit in the short run; thus, in such cases the Keynes effect drives nominal interest rates up. After borrowers and lenders have learned to expect the deflationary pressures resulting from contractionary policies, however, the Fisher effect brings nominal interest rates down.
One clear example of the Keynes and Fisher effects in action occurred during the period 1978--1982, as illustrated in panel B of Figure 8. The Federal Reserve eased monetary policy in 1978, reducing real rates of interest (the Keynes effect). During most of 1978--1980, real rates of interest were actually negative or nearly zero. By 1981, real and nominal interest rates began to soar as financial markets adjusted to higher expected inflation (the Fisher effect).
Even more recently, however, inflation in the United States steadily subsided from double-digit rates during 1983--1989, but nominal interest rates remained persistently high, as shown in Panel A of Figure 9. The eventual drop in nominal interest rates to conform to these lower rates of inflation did not fully occur until between 1990 and 1994. This delay suggests that the Fisher effect is sometimes experienced only after a long lag.
Figure 9 Recent Lags in Adjustments to Reduced Inflation
There was a relatively long delay between diminishing inflation during the 1980s and the subsequent drop in interest rates predicted by the Fisher effect. Simple natural rate theory suggests that unemployment probably exceeded its natural rate during the early 1980s, when a recession followed on the heels of a sharp recudtion of monetary growth. The consequent decline in the rate of inflation, which had been growing from the 1960s through the 1970s only slowly reduced inflationary expectations (the Phillips curve improved during the late 1980s).
Source: Economic Report of the President, 1994
Unemployment rates also trickled down during 1983-1993, but erratically, as shown in Figure 9. Thus, in the long run, natural rate theory has some predictive power about how unemployment, inflation, and interest rates are related. Critics point out, however, that long delays before interest rates and unemployment equilibrate to their "natural rates" mean that natural rate theory predicts macroeconomic movement little better than a theory that "what goes up must come down, and vice versa." In economics, as in many areas, timing is everything.
Overall, natural rate analysis suggests that active policy is futile in the long run; it cannot permanently reduce either real interest rates or unemployment. The advocates of a fixed monetary growth rule believe that discretionary policies work temporarily only if people suffer from money illusion. Even transient declines in unemployment and interest are harmful because they thwart people's desires; everyone eventually compensates for having been fooled by policymakers. But can people be fooled consistently? A recent theory answers No.