The Fisher Effect postulates a relationship between the nominal interest rate (i), the real interest rate (r), and the expected inflation rate (πe). If the government unexpectedly implements a permanent, expansionary monetary policy, how do the long-run nominal and real interest rates change according to the classical framework?

Solution: The Fisher Equation is i=r+πe. · Classical Assumption: In the long run, output (Y) is fixed at the natural rate, and the real interest rate (r) is determined solely by the balance of saving and investment (the loanable funds market), which are both determined by real variables (physical capital, technology, etc.). The real interest rate (r) is thus unaffected by monetary policy (Monetary Neutrality). · Monetary Expansion: A permanent, unexpected increase in the money supply, according to the Quantity Theory of Money, leads to an equiproportional long-run increase in the price level (P). This leads to a higher expected inflation rate (πe). · Fisher Effect: Since r is constant (neutrality) and πe increases, the nominal interest rate (i) must increase one-for-one with the increase in expected inflation.