Question

2. (a) An economy’s money supply growth is 6 per cent, real output growth is 4 per cent, and nominal interest rate is 3 per cent.

1. Find the inflation rate.                                                                 (1)

2. Find the real interest rate.                                                            (1)

        (b) How would falls of GDP growth due to Covid-19 pandemic affect inflation rate in the

         economy?                                                                                                             (2)

        (c) What policy would you recommend for the problem in (b)?                              (1)

Answer 1

i) inflation rate = money supply growth rate - real output growth rate + growth rate of velocity

= 6 % - 4 % + 0%

= 2%

Real interest rate = nominal interest rate minus inflation rate

= 3% -2%

= 1%

ii) the sum of the inflation rate and the real GDP growth rate is together known as total spending growth rate. Because aggregate demand is shifting to the left due to covid-19, the growth rate of real GDP is decreasing. This is going to reduce the rate of inflation as well because the growth rate of total spending will decline

iii) fiscal or monetary expansion is necessary to boost the aggregate demand and to maintain the growth rate of real GDP.