1. a) The growth rate of the money supply is 7%, the inflation rate is 3%, and v

Question

1.

a) The growth rate of the money supply is 7%, the inflation rate

is 3%, and velocity is constant.

What is the growth rate of real GDP? ________________

b) Suppose the real rate of interest is 3%, and the money supply is

growing at 5%. If the growth rate of the money supply

rises to 10%, then, according to the Fisher effect, what is the change in the real rate of interest? ________________

nominal rate of interest? ________________

c)

If the nominal interest rate is 8%, the expected inflation

rate is 3%, and the tax rate is 25%, what is

the after-tax real interest rate when taxes are

paid on nominal interest income?

_______________

the after-tax real interest rate when taxes are

paid on real interest income?

_______________

Explanation / Answer

a) From the below mentioned formula

Money Growth = Real GDP Growth + Inflation

We can find Real GDP growth.

Here Real GDP Growth = 7% - 3% = 4%.

b) If the real rate of interest is 3%, and the money supply is growing at 5%, then if the growth rate of the money supply rises to 10%, then, according to the Fisher effect, which states that the real interest rate equals the nominal interest rate minus the expected inflation rate,

So, the change in the real rate of interest will be zero,

but the nominal rate of interest will increase by 5% from 3%+5% = 8% to 8% + (10% - 5%) = 13%..

c) To answer this question we have to use the following formula -

Real Rate of Return = Nominal Interest Rate × (1 – Your Tax Bracket) - Inflation Rate

Real Rate of Return = 8% * (1 - 0.25) - 3%

Real Rate of Return = 3%.

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