Question

Assume that V is constant, M grows at an annual rate of 5%, Y at a rate of

2% and r= 4%.

a)

What will be the nominal interest rate?

b) How will the nominal interest rate change when the CB increases the

growth rate of money supply by 2 percentage points?

c) Assume that the growth rate of Y drops to 1%.

• How will the inflation rate change?

• What must the CB do to ensure that the inflation rate does not change?

Answer 1

If  V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4.

a)  Nominal Interest rate= real interest rate + inflation rate

We first find $\pi = 5 -2$

$\pi=3$

Therefore, $i = r + \pi$

$= 4 + 3$

$= 7$

b)

$\Delta i = 2$

It is just the same as the increase in the money growth rate.

$π=5−2$

$π=3$

Hence, $i = r + \pi$

$=4+3$

$= 7$

c)

The central bank does nothing $\Delta \pi =1$. For the central bank to prevent inflation from rising, it must reduce the money growth rate by $1\%$ point per year