Question

1. Calculate the disposable income from the following table:

Flows in the economy of Classica

Total Output (GDP) Total Income Consumption Spending (C) Private Investment (I) Government Purchases (G) Net Taxes (T) Household Savings (S)

$10 trillion $10 trillion $7 trillion $1 trillion $2 trillion $1.25 trillion $1.75 trillion

1. Suppose the nominal interest rate is currently 5 percent.

1. If the inflation rate is zero, what is the real interest rate?
2. The inflation rate decrease to -1 percent while the nominal interest rate remains at 5 percent. Does it make sense to lend money under these circumstances?

Answer 1

The disposable income can be calculated as:

Total income minus Net Taxes

= $10 trillion minus $1.25 trillion

Disposable income = $8.75 trillion

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This can be verified by:

Disposable income = Saving + Consumption

Yd = $7 trillion + $1.75 trillion = $8.75 trillion

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a) If nominal interest rate is 5%, and inflation is zero,

the real interest rate is also 5%

real interest rate = nominal interest rate minus inflation

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b) If nominal interest rate is 5%, and inflation is (-1)%,

the real interest rate is actually 6%

If you lend out money when inflation is low or negative, you actually end up receiving more than what you should have received.

For example, you lend out money at 5%, but what you receive is actually 6%.

When there is negative inflation, lenders are benefited, because the money they receive has higher purchasing power in real terms.