Question

2 Understanding and Calculating Inflation Real and Nominal Interest Rates in the United States, 1960-2015 Percent 16 14 Nominal Real 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Year Figure 2: Real and nominal interest rates in the US, 1960-2015 1. State the Fisher equation. What do the three variables in Fisher's equation represent? 2. Consider Figure 2. Why do negative real interest rates occur? Are they a problem for the economy? 3. In Figure 2, is there any period during which the nominal interest rates in the economy has been negative? How low has it gone? Can it go lower? 4. Suppose you are the head of the central bank and your mandate is to maintain the price level at a constant value. Explain what you would do to the money supply in response to each of the following events: (a) Real GDP increases by 4% during a boom. (b) Real GDP declines by 1% during a recession. (c) The velocity of money declines by 1%

Answer 1

1)

Fisher Equation is as follows:

(1 + i) = (1 + r) (1 + π)

Where:

i – the nominal interest rate

r – the real interest rate

π – the inflation rate

However, one can also use the approximate version of the previous formula: i ≈ r + π

2)

Negative real interest rates occur when Inflation is greater than the nominal interest rates in the eonomy. Yes, it can be a huge problem in the economy as it is like you are losing your money everyday because of such high inflation and lesser interest rates on money deposited in bank.

3)

No, there has been no period during which the nominal interest rates in the economy have been negative. The lowest it has gone is upto 0% . It cannot go lower because if banks charged a negative nominal interest rate, you would be paying the bank to deposit your own money there, which is simply irrational as one would then keep money at their homes and not deposit it.

4)

a) If real GDP increases by 4% during a boom, the central bank should decrease the money supply to reduce spending. Money supply can be decreased by increasing Repo Rate, selling government bonds etc.

b) If real GDP declines by 1% during a recession, the central bank should increase the money supply to increase spending. Money supply can be increased by decreasing Repo Rate, or buying government bonds etc.

c) Velocity of money = Nominal GDP / Quantity of money

If velocity of money declines by 1%, the Central Bank should lower the interest rates to increase the Aggregate Demand in the economy.