W2P2 Money and Inflation Flashcards
What is the Fisher Equation formula?
r = i - π^e
where:
r = the real interest rate
i = the nominal interest rate
π^e = inflation expectations
Suppose the inflation rate in Turkey is expected to be about 10% per year over the next year, what does the Fisher equation predict for the nominal interest rate if the real interest rate is 5%?
rearrange the fishers equation to make i the subject
i = r + π^e
sub in values from q:
r=5% and π^e=10%
i=5%+10%=15%
Suppose the inflation rate turns out to be 15% over the year (π=15%). Were the borrowers or
lenders the winners if they had made contracts according to a 15% nominal interest rate (i)?
Real interest rate (r) is now:
r=i-π -> r=15%-15%=0
Thus, i=15%, r is now lower than anticipated and hence borrowers are better off.
Suppose inflation turns out to be 10% over the next year, and nominal GDP grows
at 12%. What is rate of growth of real GDP?
Real GDP will grow by the growth rate of nominal GDP minus the inflation rate. Hence, real GDP will grow by:
gY,real = gy,nom - π
gY,real = 12% - 10%
gY,real = 2%
Suppose a growth rate of 2% is maintained over several years, and the income elasticity of money demand is 0.5. What is the rate of nominal money
growth?
π = inflation
µ = nominal money growth rate
n = the income elasticity of money demand
gY,Real = growth rate of real GDP
from Q:
gY,Real = 2%, π=10%, n=0.5
µ-π=n(gY,Real)
µ=n(gY,Real)+π
µ=0.5(2%)+10%
µ=11%
So nominal money supply would need to grow by 11% to keep interest rates stable. If the money supply was growing by less, then interest
rates would increase. If the money supply was growing by more, then interest rates would decrease.
Why was it important to include that growth rates are maintained over “several years” in the previous question?
In the short-run prices are sticky, i.e. they would not adjust immediately to changes in the money supply. The above equation is therefore
a long-run relationship
