Question

1 Assume that the demand for real money balance (M/P) is M/P = 0.6Y – 100i, where Y is national income and i is the nominal interest rate (in percent). 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.

a. If Y is 1,000, M is 100, and the growth rate of nominal money is 1 percent, what must i and P be?

b. If Y is 1,000, M is 100, and the growth rate of nominal money is 2 percent, what must i and P be?

2. In classical macroeconomic theory, the concept of monetary neutrality means that changes in the money supply do not influence real variables. Explain why changes in money growth affect the nominal interest rate, but not the real interest rate.?

3. Although “inflation is always and everywhere a monetary phenomenon,” explain why:

a. the start of a hyperinflation is typically related to the fiscal policy situation, and

b. the end of a hyperinflation is usually related to changes in fiscal policy.

Answer 1

1. a) Inflation rate = Nominal interest rate - Real interest rate

Inflation rate = Growth rate of nominal money = 1%

1% = Nominal interest rate - 3%

Nominal interest rate, i = 4%

M/P = 0.6Y - 100i

100/P = 0.6 x 1000 - 100(4)

100/P = 600 - 400

100/P = 200

P = 1/2 = 0.5

b) Inflation rate = Nominal interest rate - Real interest rate

Inflation rate = Growth rate of nominal money = 2%

1% = Nominal interest rate - 2%

Nominal interest rate, i = 3%

M/P = 0.6Y - 100i

100/P = 0.6 x 1000 - 100(3)

100/P = 600 - 300

100/P = 300

P = 1/3 = 0.33