Question

Consider the following: -Money grows at a rate of 6% -Velocity is constant -Output grows at a rate of 3% The real interest rate is 2.5% Find the nominal interest rate.

Answer 1

For this answer let's begin with the quantity theory of money. It states that MV=PY.

We can consider the quantity equation with respect to percentage change/ growth rate as well.

Growth rate of M× Growth of V = Growth rate of P × Growth rate of Y.

Now since growth of V is constant then total growth on the left hand side of the quantity equation is 6%. While on the right hand side it's given that growth rate of Y(output) is 3%. Based on the quantity equation both lhs and rhs should be equal. So we can find growth rate of P =

growth rate of M/growth rate of Y = 6/3 = 2%

So inflation in the economy is 2%

Given real interest rate is 2.5 %

From the Fisher equation we know that -

Nominal interest rate = real interest rate + Inflation.

Hence nominal interest rate = 2.5% + 2% = 4.5%