Question

In Monetaria real GDP is growing at 2% per year and the money supply is growing at 5% per year. Suppose that the velocity of money has been constant

a) Find the inflation rate.

b) The nominal interest rate is 10%. Find the real interest rate, assuming that inflation will remain the same

c) Suppose you are a small hats retailer. To simplify the analysis, let’s assume that the only costs of doing business is paying for the merchandise you are selling. Suppose that you need to pay for the hats in December 2019 and you sell them a year later in December 2020. (Realism is not the point.) Suppose that the wholesale price of a hat is 10$, you expect to be able to sell a hat for 12$ in December 2020 and you need to borrow money to buy the hats.

What is the profit per hat? (Hint: the interest you pay on the loan is part of your costs).

d) Suppose that inflation rose unexpectedly to 10%. Suppose that you are able to raise your prices by the additional inflation. The interest rate on your loan remains unchanged. Now what is your profit per hat?

Answer 1

A) inflation= money growth- real gdp growth=5-2=3%

B) real interest rate= nominal interest rate- inflation=10-3=7%

C) nominal interest rate=10% or 0.1

Interest rate on per hat bought=10*0.1=1$

So Profit per hat=12-10-1=1$

D) So retailer will increase,so that his real Profit per hat remain same.

When inflation was 3% , nominal value was 1$

1.03x=1

x=1/1.03( real value)

When inflation is 10%

Nominal value=(1/1.03)*1.1=1.068

So he required 1.068$ Profit per hat to get same real Profit.

New Profit per hat=1.068$