LaunchPad for Krugman's Macroeconomics (Six Month Access)
4th Edition
ISBN: 9781319011024
Author: Paul Krugman, Robin Wells
Publisher: Worth Publishers
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Question
Chapter 10, Problem 10P
To determine
Change in Interest Rate: Interest rate depends on several factors. One such factor is expected inflation rate. The relationship of interest rate and inflation rate is described by the Fisher effect.
Inflation: When the price of any good increases continuously for an interval of time it is called inflation. The formula to calculate inflation rate is:
Fisher Effect: According to this effect, when there is a rise in the expected inflation rate, then there is always a rise in the nominal interest rate provided loanable fund quantity and interest rate does not change.
Expert Solution & Answer
Answer to Problem 10P
a. When Real inflation Rate is 4%
Given,
Nominal interest rate is 8%.
Real interest is3%.
Expected inflation is 5%.
The formula to calculate real interest rate is:
Substitute 8% for nominal interest rate and 4% for inflation rate as follows:
Explanation of Solution
- If the real inflation is 4%, then it means that the real interest paid by Mr. B is 4%. However, at the initial agreement (expected inflation 5%), he was paying only 3% as real interest.
- This shows that Mr. B is worse off and Mr. L is better off.
b. When Real inflation Rate is 7%
The formula to calculate real interest rate is:
Substitute 8% for nominal interest rate and 7% for inflation rate as follows:
- If the real inflation is 7%, then it means that real interest paid by Mr. B is 1%. However, at the initial agreement (at 5% expected inflation), he was paying 3% as real interest.
- This shows that Mr. B is better off and Mr. L is worseoff because now the real interest paid by Mr. B is less than earlier.
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Chapter 10 Solutions
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