TUTORIAL 9 (Expectation – Basic Tools) SOLUTION

(Answers are provided as a guide but not limited to the following)

1. First, explain what nominal interest rate represents. Next, explain what real interest
rate represents.

Suggested answer:

The following expressions,

rt  it   et + 1
where i the nominal interest rate, represents the amount of dollars one must repay in the
future in exchange for borrowing one dollar today: 1 + i. Therefore, i represents the cost
of borrowing dollars in terms of dollars. Nominal interest rate in determined in financial
market.

The following expressions,

rt  it   et + 1
where r the real interest rate, represents the amount of goods one must repay in the future
in exchange for borrowing one unit of a good today: 1 + r. Therefore, r represents the cost
of borrowing goods in terms of goods. Real interest rate is determined in real sector or
goods market.
2. Explain whether it is possible for the nominal interest rate to increase while the real
interest rate simultaneously decreases.

Suggested answer:

The nominal interest (i) rate is determined in financial markets. The real interest rate (r) is
approximately equal to i - e where e is expected inflation. When i increases, r can fall if
the increase in expected inflation exceeds the rise in nominal interest i. As such, it is
possible for nominal interest rate to increase while real interest rate decreases
simultaneously.

3. Using the IS-LM model, graphically illustrate and explain what effect an increase in
money growth will have on output, the nominal interest rate, and the real interest rate
in the short run.

Suggested answer:

An increase in money growth will cause the LM curve to shift down. This will lower the
nominal rate. Assuming expected inflation does not change, the real rate will fall by the
same amount. Investment will increase causing an increase in demand and output.
4. Explain what effect an expansionary monetary policy by central bank will have on the
nominal interest rate in both short run and medium run.

Suggested answer:

In the short run, a monetary expansion executed by Central Bank can influence directly
both nominal and real interest rate by lowering both nominal and real interest rate, given
no changes to expected inflation. This means central bank can directly affect the nominal
interest rate in the short run.

However, in the medium run, as people starts to form expectation about inflation, the
nominal rate will equal the natural real rate plus inflation (Fisher effect). The Central
Bank cannot influence the nominal interest rate directly in the medium run. However,
by altering money growth (money supply), the central bank can affect inflation.

As such, by changing the rate of growth of money, the Central Bank can indirectly
affect the nominal interest rate in the medium run where nominal interest rate will
rise higher when inflation rises while real interest rate will return to its natural rate.
This is known as “Fisher Effect”.
5. Explain what effect an expansionary monetary policy by central bank will have on the
real interest rate in the short run and in the medium run? Explain.

Suggested answer:

The real rate in the medium run is determined by real factors. The central bank cannot
change the real rate in the medium run. It is possible for monetary policy to affect the real
interest rate in the short run, ie an increase in growth of money will lead to decrease in both
nominal and real interest rate as shown in slide below.
 The money growth following monetary expansion in short run causes inflation to rise
by the same rate over time, leading to rise in nominal interest rate by the same rate as money
growth in medium run causing real interest rate to revert to its natural level of rn.

6. Explain what the Fisher effect/Fisher hypothesis represents.

Suggested answer:

The Fisher effect represents the relationship between expected inflation and the nominal
interest rate. As inflation expectation increases, the nominal interest rate will tend to rise.