Intermediate Macroeconomics - Eco 3311
Practice Question # 4
Instructor: Menelik Geremew
1. Assume that a series of inflation rates is 1 percent, 2 percent, and 4 percent, while nominal
interest rates in the same three periods are 5 percent, 5 percent, and 6 percent,
a. What are the ex post real interest rates in the same three periods?
b. If the expected inflation rate in each period is the realized inflation rate in the previous
period, what are the ex ante real interest rates in periods two and three?
c. If someone makes a loan in period two, based on the ex ante inflation expectation in
part b, will he or she be pleasantly or unpleasantly surprised?
2. 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. 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?
3. A classical economist wears a T-shirt printed with the slogan “Fast Money Raises My
Interest!” Use the quantity theory of money and the Fisher equation to explain the slogan.
4. 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.
5. Econoland finances government expenditures with an inflation tax.
a. Explain who pays the tax and how it is paid.
b. What are costs of the tax, assuming the tax rate is expected?
6. If the demand for money depends positively on real income and depends inversely on the
nominal interest rate, what will happen to the price level today, if the central bank
announces (and people believe) that it will decrease the money growth rate in the future,
but it does not change the money supply today?
7. 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.