INFLATION QUESTION AND ANSWERS
1. Suppose V is constant, M is growing 5% per year, Y is growing 2% per year,
and r = 4.
(a) Solve for i (the nominal interest rate).
First, find = 5 2 = 3. Then, find i = r + = 4 + 3 = 7.
(b) If the ECB increases the money growth rate by 2 percentage points
per year, find i .
i = 2, same as the increase in the money growth rate.
(c) Suppose the growth rate of Y falls to 1% per year. What will happen
to ? What must the ECB do if it wishes to keep constant?
If the ECB does nothing, = 1. To prevent inflation from rising, the ECB must
reduce the money growth rate by 1 percentage point per year.
2. You read in a newspaper that the nominal interest rate is 12 per cent per year
in Sweden and 8 per cent per year in the UK. Suppose that the real interest rates
are equalized in the two countries and that purchasing power parity holds.
(a) Using the Fisher equation, what can you infer about expected inflation in
Sweden and in the UK?
The Fisher equation says that:
i = r + πe
where:
i = the nominal interest rate
r = the real interest rate (same in both countries)
πe = the expected inflation rate.
Plugging in the values given in the question for the nominal interest rates for
each country, we find:
12 r SW
e
EDEN
8 r UeK
This implies that
1
1. Suppose V is constant, M is growing 5% per year, Y is growing 2% per year,
and r = 4.
(a) Solve for i (the nominal interest rate).
First, find = 5 2 = 3. Then, find i = r + = 4 + 3 = 7.
(b) If the ECB increases the money growth rate by 2 percentage points
per year, find i .
i = 2, same as the increase in the money growth rate.
(c) Suppose the growth rate of Y falls to 1% per year. What will happen
to ? What must the ECB do if it wishes to keep constant?
If the ECB does nothing, = 1. To prevent inflation from rising, the ECB must
reduce the money growth rate by 1 percentage point per year.
2. You read in a newspaper that the nominal interest rate is 12 per cent per year
in Sweden and 8 per cent per year in the UK. Suppose that the real interest rates
are equalized in the two countries and that purchasing power parity holds.
(a) Using the Fisher equation, what can you infer about expected inflation in
Sweden and in the UK?
The Fisher equation says that:
i = r + πe
where:
i = the nominal interest rate
r = the real interest rate (same in both countries)
πe = the expected inflation rate.
Plugging in the values given in the question for the nominal interest rates for
each country, we find:
12 r SW
e
EDEN
8 r UeK
This implies that
1
