Suppose that the nominal rate of interest is 4 percent and the inflation premium

Question

Suppose that the nominal rate of interest is 4 percent and the inflation premium is 2 percent. a. What is the real interest rate? b. Alternatively, assume that the real interest rate is 1 percent and the nominal interest rate is 6 percent. What is the inflation premium? Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth and that investment spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. Also assume that the economy's multiplier is 4. a. If household wealth falls by 5 percent because of declining house values, and the real interest rate falls by?2 percentage points, in what direction and by how much will the aggregate demand curve initially shift at each price level? by- billion. The aggregate demand curve will shitt b. Also assume that the economy's multiplier is 4. In what direction and by how much will it eventually shift? by billion. The aggregate demand curve will shift Refer to the figure above.

Explanation / Answer

(3)

(a) Real interest rate = Nominal interest rate - Inflation premium = 4% - 2% = 2%

(b) Inflation premium = Nominal interest rate - Real interest rate = 6% - 1% = 5%

(4)

(a) Initially,

When household wealth falls by 5%, Consumer spending falls by [$5 billion x (5% / 1%)] = $25 billion.

When real interest rate falls by 2%, Investment rises by [$20 billion x (2% / 1%)] = $40 billion.

Aggregate demand will shift Rightward by $15 billion (= Rise in investment - Fall in consumption = $(40 - 25) billion].

(b) Eventually,

Initial increase in aggregate demand = $15 billion

Eventually Aggregate demand will shift Rightward by $60 billion (= Initial increase x Multiplier = $15 billion x 4).

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