Answer to Question #100060 in Macroeconomics for Tiffany

Question

b. Explain the relationship between interest rates and unemployment. How do changes in the interest rate affect the level of unemployment in the economy?
Answer:

c. Consider the relationship between interest rates and inflation.
(i) Explain the difference between real and nominal interest rates.
Answer:

(ii) If the Fed takes actions that will change interest rates, how is this likely to affect inflation?
Answer:

Answer 1

b.When interest rate in an economy increases(decreases), then the investment opportunities decrease(increase). Firms take less (more) credit from the market, due to which less(more) production is done by them which further decreases(increases) the demand for labor in the market. With the lower(higher) demand for labor, firms lay out employs,which decreases(increases) the employment in an economy. The interest rate and unemployment has inverse relationship.

c. i) The difference between nominal and real interest rates, lies in the inflation rate. Real interest rate considers the change in inflation rate, where as nominal interest rate is unaffected by inflation rate.

Real interest rate = Nominal interest rate - inflation rate

r = i - $\prod$

ii) When Fed increases(decreases) interest rate in an economy, the money demand decreases(increases) in the economy. With increasing(decreasing) interest rate, consumption and investment decreases(increases) in the economy, which leads to decreased(increased) aggregate demand. This reduction(increase) in aggregate demand, given aggregate supply is constant, will generate surplus(shortage) in the market. This surplus will reduce(increase) the prices in the economy, and this decreases(increases) the inflation rate.