Inflation and Real Money Balance

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MECO-121
Assignment # 2 (Section: 1)

Instructor: Daud Ahmed Dard
Group: 10
Group Members:
1. Naima Iram (16110001)
2. Ridaah Zargham (16110100)
3. Saeeba Ali (16110015)
4. Afrose Dar (16110269)
5. Habib Ehtisham (16110141)
6. Rukham Khan (16110020)

Question 11:
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?

Solution:
a. M/P = 0.6Y-100i
r = 3%
Expected inflation = rate of nominal money growth
Y = 1,000
M = 100

Finding the value of nominal interest rate using real interest rate and expected inflation: i= r + expected inflation
i = 3+1
i = 4

Substituting the value of “i” in the demand for real money balance equation: M/P = 0.6Y-100i
100/P = 0.6(1,000)-100(4)
100/P = 600-400
P = 100/200
P = ½ = 0.5

b. Y = 1,000
M = 100
Growth rate of nominal money = Expected rate of inflation = 2% Finding the value of nominal interest rate using real interest rate and expected inflation: i = r + expected inflation
i = 3 + 2
i = 5

Substituting the value of “i” in the money demand function: M/P = 0.6Y-100i
100/P = 0.6(1,000)-100(5)
100/P = 600-500
P = 100/100
P = 1
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