FRQ # 5

 

Inflation and expected inflation are important determinants of economic activity.

1. Thinking in terms of the Phillips curve how would you show the effect of an increase in the expected rate of inflation.
   
   
2. What is the effect of the increase in the expected rate of inflation on the long-run Phillips curve?
   
   
3. Given the increase in the expected rate of inflation from part (b),
1.  will the nominal interest rate on new loans increase, decrease, or remain unchanged? 
2. will the real interest rate on new loans increase, decrease, or remain unchanged?
   
   
4. Assume that the nominal interest rate is 8 percent. Borrowers and lenders expect the rate of inflation to be 3 percent, and the growth rate of real gross domestic product is 4 percent. Calculate the real interest rate.

Using the graph and definitions below of the supply of loanable funds, SLF, and the demand for loanable funds, DLF, discuss the following:

a. What is meant by the equilibrium nominal rate of interest?

b. Illustrate and discuss how an autonomous increase in the expected rate of inflation will change the equilibrium nominal interest rate. Express your discussion in terms of the effect on the supply and demand for loanable funds. Consider an initial real rate of interest of 3 percent and an expected inflation rate of 3 percent. If the expected rate of inflation rises to 4 percent with the real interest rate constant, what would the resulting nominal interest rate become in equilibrium using the Fisher relationship? Assume that investors believe the rise in the expected rate of inflation will remain at the higher level indefinitely.

c. Starting from an equilibrium position as in a, discuss the effects of a tightening monetary policy if the markets believe that a Fed tightening will lower future (next period) inflation. How might a recession occur under this scenario? HINTS: Recall the Fisher relationship where (1+i) = (1+r)(1+pe), where i is the nominal interest rate, r is the required real rate of return before taxes, and pe is the expected rate of inflation.

6.As the result of unanticipated inflation, borrowers are better off while lenders are worse off if the actual inflation rate
Select one:
a. exceeds the expected inflation rate.
b. is equal to the expected inflation rate.
c. is less than the expected inflation rate.
d. Neither borrowers nor lenders are better off as the result of unanticipated inflation.

7.In the short run, decreases in the money supply will
Select one:
a. decrease real interest rates.
b. increase real interest rates.
c. may increase or decrease real interest rates.
d. have no effect on real interest rates.

8.What would happen to prices if, for example, all trade unions negotiated long-term higher nominal pay and regular across-the-board increases for workers?
Select one:
a. Prices would remain unchanged.
b. Prices would likely increase.
c. Prices are not affected by nominal salary increases.
d. Prices would likely decrease.

9.As the result of unanticipated inflation, workers are better off while firms are worse off if the actual inflation rate
Select one:
a. is equal to the expected inflation rate.
b. exceeds the expected inflation rate.
c. is less than the expected inflation rate.
d. Neither firms nor workers are better off as the result of unanticipated inflation.

10.If the velocity of money is 4 and nominal GDP is $24 trillion, then the money supply is
Select one:
a. $28 trillion.
b. $20 trillion.
c. $6 trillion.
d. $0.167 trillion.

3. Suppose that a typical taxpayer has a marginal personal income tax rate of 20 percent. The nominal interest rate is 4 percent, and the expected inflation rate is 1 percent.

a. What is the real after-tax rate of interest?

b. Suppose that the expected inflation rate increases by 2 percentage points to 3 percent, and the nominal interest rate increases by the same amount. What happens to the real aftertax rate of return?

c. If the inflation rate increases as in part b, by how much would the nominal interest rate have to increase to keep the real after-tax interest rate at the same level as in part a? Can you generalize your answer using an algebraic formula?