THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 139

CHAPTER 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 - 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