Q1. In a country, the velocity of money is constant. Real GDP grows by 5% per year, the money stock by 14% per year, and the nominal interest rate is 11 per cent. What is the real interest rate?
The following is provided in the question
GDP growth rate (Y)- 5%
Money Stock growth rate (M)-14%
Nominal Interest Rate- 11%
Velocity Of Money- Constant
Real Interest Rate = Nominal interest rate - Inflation ...................... Fisher Effect By the quantity equation we have;
M .V = P.Y
The Quantity theory of Money assumes that V is constant and exogenous. Inflation= Change in the Money Growth- Change in the GDP Growth Using the above values
Inflation= 14% - 5% = 9%
Real Interest Rate = 11%- 9%= 2%
Therefore the real interest rate is adjusted for inflation.
Q.2 Suppose a country has a money demand function (M/P)d = kY, where k is a constant parameter. The money supply grows by 12% per year, and real income grows by 4% per year. (a) What is the average inflation rate?
(b) How would inflation be different if real income growth were higher, say 6%? Explain. (c) Suppose, instead of a constant money demand function, the velocity of money in this economy was growing steadily, say by 2% per annum because of financial innovation. How would that affect the inflation rate? Explain.
The Money demand function (M/P)d = kY, where
M/P = Real Money Balances
k= money people wish to hold for each rupee of income and k= 1/V (a) Average Inflation Rate
12%- 4%= 8%
(b) If Y=6%, then Inflation is
12% - 6 %= 6%
Inflation depends upon changes (in this increases) in the Money Supply and Real Income, which is given by the quantity theory of money. So if the money growth rate is greater than the real income growth rate it results in Inflation. In the (a) the money growth rate was 12% whereas real income growth rate is 4% so the Inflation rate is 8%, whereas in (b) the real income growth rate has increased to 6% and hence the inflation...
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