Assignment Details

Subject: General Questions / General General Questions

Question

ECO 305 — Spring 2017

——-Assignment 4——Please, note the following: You must walk us through your answers and give us the economic intuition behind your solution. Otherwise you will

not obtain any points, EVEN THOUGH your answer might be correct.

In your explanations, use whole sentences and a clear syntax, similarly to the textbook.

Whenever it is not explicitly required, it is up to you to use equations and/or graphs in your answers.

If you use equations, remember to define each variable and what the equation stands for.

If you use graphs, remember to label clearly the a. axes; b. curves; c. initial equilibrium point(s); d. terminal or final

equilibrium point(s); and e. the direction the curves shift.

Note there might be more than one way to correctly answer a question.

Regardless of how you organize/distribute the work, both members of the partnership must be able to complete the

whole assignment. …………………………………………………………………………………………………………………………

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, respectively.

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 lends in period two, based on the ex ante inflation expectation in part b, will he or

she be pleasantly or unpleasantly surprised in period 3 when the loan is repaid?

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 (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?

3. 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?

4. Consider two countries, Hitech and Lotech. In Hitech new arrangements for making payments, such as

credit cards and ATMs, have been enthusiastically adopted by the population, thereby reducing the

proportion of income that is held as real money balances. Over this period no such changes occurred in

Lotech. If the rate of money growth and the growth rate of real GDP were the same in Hitech and Lotech

over this period, then how would the rate of inflation differ between the two countries? Carefully explain

your answer. Page 1 5. 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.

6. Interest rates played a part in the 1984 U.S. presidential debates. Some politicians claimed that interest rates

rose over the 1981–1983 period, while others claimed rates fell. Below is a table showing interest rates and

annual inflation rates from 1981 to 1983.

Interest Rate

Annual

Year

(annual %)

Inflation Rate

1981

14.03%

10.3%

1982

10.69%

6.2%

1983

8.63%

3.2%

Reconcile these conflicting claims.

Extra Credit Question

7. Go to the Federal Reserve Open Market Committee (FOMC) page of the Federal Reserve Board’s website1 and

find the most recent statement issued after the most recent FOMC meeting.2

a) What is the date of this meeting? What is the target Federal Funds rate?

b) Is the above target rate different from the target in the previous FOMC statement?3 If yes, by how much does

it differ?

c) Does the statement comment on current macroeconomic conditions in the US? How does it describe the US

economy? What is the target inflation rate? Use your own words to explain (do NOT copy and paste).

d) Suppose now the target inflation rate has been attained but 8.5% of the labor force is unemployed. If you were

in the FOMC, what action would you prescribe? How would this affect the inflation rate? The interest rate?

Why?

e) Suppose all is as in (d), your recommendation is implemented and, in the short run, the increase in money

supply pushes interest rates down. What is the impact on the economy (consumption, investment, GDP)?

What is now the impact on the inflation rate? On unemployment? 1

2

3 https://www.federalreserve.gov/monetarypolicy/fomc.htm

Click on “Meeting calendars and information” and then click on the most recent statement listed in the calendar.

You will have to look into last calendar year’s statements. Page 2