Question

Assume that the real money balance (M/P) is M/P=0.6Y-100i, where Y is the national income and I is the nominal interest rate. The real interest rate "r" is fixed at 3 percent by the investment and saving functions. The expected inflation rate equals the rate of nominal money growth.

-If Y is 1,000, M is 100, and the growth rate of nominal money is 2.5%, what must "i" and "P" be?

-If Y is 1,000, M is 100 and the growth rate of nominal money is 2.75%, what must "i" and "P" be?

Answer #1

At equilibrium, we have M/P = 0.6Y - 100i,

Here real interest rate "r" is fixed at 3 percent and expected inflation rate = rate of nominal money growth.

If Y is 1,000, M is 100, and the growth rate of nominal money is 2.5%, we have expected inflation rate = 2.5% and nominal interest rate = real interest rate + expected inflation rate = 3% + 2.5% = 5.5. Then we have

100/P = 0.6*1000 - 100*5.5

100/P = 600 - 550

P = 100/50 = 2.

Hence i = 5.5 and P = 2.

-If Y is 1,000, M is 100 and the growth rate of nominal money is 2.75%, we have expected inflation rate = 2.75% and nominal interest rate = real interest rate + expected inflation rate = 3% + 2.75% = 5.75. Then we have

100/P = 0.6*1000 - 100*5.75

100/P = 600 - 575

P = 100/25 = 4.

Hence i = 5.75 and P = 4.

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