Question

Assume that the demand for real money balance, (M/P) d = 0.5Y – 200i, where Y is national income and i is the nominal interest rate (in percent). The real interest rate r is fixed at 2 percent by the investment and saving functions. The expected inflation rate is 1 percent, real GDP is 5,000 and the money supply is 209,110.

a. What is the nominal interest rate?

b. What is the price level?

c. Now suppose Y is 2,000, M is 42,000, what must i and P be?

Answer 1

(a)

Nominal interest rate (i) = r + e

where r = real interest rate, e = expected inflation

Here, r = 2% and e = 1%

hence i = 2 + 1 = 3%

Hence Nominal interest rate = 3%

(b)

At equilibrium (M/P)^d = (M/P)^s = 0.5Y – 200i, Here M = Money supply = 209110 , Y = 5000, i = 3

Hence, 209110/P = 0.5*5000 – 200*3 => P = 110.06

Hence Price level = 110.06  

(c)

Nominal interest rate (i) = r + e

where r = real interest rate, e = expected inflation

Here, r = 2% and e = 1%

hence i = 2 + 1 = 3%

Hence Nominal interest rate = 3%

At equilibrium (M/P)^d = (M/P)^s = 0.5Y – 200i, Here M = Money supply = 42000 , Y = 2000, i = 3

Hence, 42000/P = 0.5*2000 – 200*3 => P = 105

Hence Price level = 105