Question

1. i) Write down the relationship between real interest rate, nominal interest rate, and expected inflation. ii) Using the relationship from i), fill in the following table. iii) What does the Fed hope when it engages in monetary expansion to get the economy out of recession? iv) Which situation(s) in the filled-in table corresponds to Zero Lower Bound? v). Use two rows of the completed table to explain why with Zero Lower Bound is it necessary to have positive expected inflation to have a greater success in getting out of recession. Nominal Expected Real Interest Rate Inflation Interest Rate T

Answer 1

1.

i.

Real Interest rate = Nominal interest rate - inflation rate

ii.

Nominal Interest Rate Expected Real Inflation Interest Rate

iii.

Monetary expansion by Fed, leads to increase in the money supply. It is expected to decrease the interest rate so that cost of borrowing decreases. It should lead to increase in consumption and investment spending. As a result, AD increases and economy comes out of the recession.

iv.

Situation C and D show the zero lower bound, because these two situations have zero nominal interest rate.

v.

With row C and D, it can be seen that with zero lower bound, when inflation rate is positive, then it is a favorable condition for the borrowers (either firms or households). It makes these entities to borrow more and stimulate the demand. If inflation is negative, then real rate is positive. It makes people to hold onto the money and spending decreases. It creates the problem of liquidity trap.