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Homework Answers
1) There are two groups of variables. The first group is nominal variables, which are measured in monetary units. The second group is real variables, which are measured in physical units. The separation of nominal and real variables is called classical dichotomy.
2) A real interest rate is an interest rate that has been
adjusted to remove the effects of inflation to reflect the real
cost of funds to the borrower and the real yield to the lender or
to an investor. A nominal interest rate refers to the interest rate
before taking inflation into account.
They are related as:
real interest rate = nominal interest rate - expected rate of
inflation
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Question 1 (10 points] What is meant by the separation of real and nominal values...
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Question 5 [10 points] If inflation rises from 6 to 8 percent, what happens to real and nominal interest rates according to the Fisher effect?
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Use the following Taylor rule to calculate what would happen to
the real interest rate if inflation increased by 7 percentage
points.
Target federal funds rate
= Natural rate of interest + Current inflation + 1/2(Inflation gap)
+ 1/2(Output gap)
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