Economics 305 Dr.

Neri
Problem Set No. 4 due in class on Friday October 3

1. Assume that a series of inflation rates is 1 percent, 2 percent, and 4 percent, while nominal
interest rates in the same three periods are 5 percent, 5 percent, and 6 percent, respectively.

a. What are the ex post real interest rates in the same three periods?
b. If the expected inflation rate in each period is the realized inflation rate in the previous
period, what are the ex ante real interest rates in periods two and three?
c. If someone makes a loan in period two, based on the ex ante inflation expectation in
part b, will he or she be pleasantly or unpleasantly surprised?

2. Assume that the demand for real money balance (M/P) is M/P = 0.6Y -100i, where Y is
national income and i is the nominal interest rate. The real interest rate r is fixed at 3 percent
by the investment and saving functions. The expected inflation rate equals the rate of nominal
money growth.

a. If Y is 1,000, M is 100, and the growth rate of nominal money is 1 percent, what must i
and P be?
b. If Y is 1,000, M is 100, and the growth rate of nominal money is 2 percent, what must i
and P be?

3. Suppose V is constant, M is growing 4.5% per year, Y is growing 3% per year, and
r = 2.5.

a. Solve for i (the nominal interest rate).

b. If the Fed increases the money growth rate by 2 percentage points per year to 6.5%,
what will be the impact on the nominal interest rate?
c. Set the growth rate in M back to 4.5%. Suppose the growth rate of Y falls to 1% per
year.
What will be the impact on the rate of inflation ()?
Solve for the nominal interest rate.
What must the Fed do if it wishes to keep  constant?

4. Suppose as the result of a speech by the Fed Chairman, market participants expect the rate
of inflation to be higher next year and in the future. The current rate of growth in the money
supply is unchanged.
a. What will be the impact on the demand for money? Explain why?
b. What will be the impact on the velocity of money? Explain why?
c. What is the impact on Y? Explain why?