Real Interest, Nominal Interest and Inflation
Q1. 6 Marks
Real Interest, Nominal Interest and Inflation 20
Percent
15 10
Nominal Interest Rate Inflation Real Interest rate
5
10
20
04 07 20
20
98 01 20
19
92 95 19
19
86 89 19
19
-5
19
19
80 83
0
Year
Comment Since the early 1980s, real interest rates have been in decline. What is notable about the real interest rates in the late 2000s? The notable feature of the real interest rate series is that since 2004s they are low and, for the last couple of years they are almost zero or negative. What might explain the low real interest rates of the last couple of years? Aside from historically low nominal interest rates in order to boost the economy out of recession, the most straightforward explanation for these negative real interest rates is that inflation expectations were consistently too low. Recall that the calculated real interest rates are ex post; that is, they are calculated using actual inflation not the inflation rate that borrowers and lenders expected. If inflation was consistently higher than expected inflation, nominal interest rates would have not fully compensated for the inflation that occurred. One effect of this is to make borrowers better off at the expense of lenders; that is, there is a transfer of resources from lenders to borrowers. Although this seems to be at least part of what happened, it does raise the question as to how people systematically under-predicted inflation. The other explanation for the low real interest rates is that it reflects the equilibrium outcome of saving and investment decisions; for example, low demand for investment would, all else equal, contribute to lower real interest rates.
Q2. a) 6 Marks
Q2 b) 8 Marks i) National savings = Y-C-G = 5000 – 900- 0.6(3000)-1000 = 1300 Investment = 2500- 100(r*) = 2500- 1000 = 1500 NX= S-I = 1300 – 1500 = -200 NX = -200 = 2000- 500 E -> E= 4.4 ii) If r=5, then I = 2500 – (100*5)= 2000 Now, NX = S-I = 1300- 2000 = -700 And -700 = 2000 – 500E -> E=5.4 iii) Graphically,
Q3 a) 4 Marks
Q3 b) 6 Marks
Q4. 20 Marks
In addition, MPK=dy/dk= 0.5k^-0.5 for both countries For Country A: MPK= 0.5(4)^-0.5 = 0.25 And MPK-δ= 0.25-0.05=0.2
For Country B: MPK=0.5*(16)^-0.5=0.125 And MPK- δ=0.125-0.05=0.075 In both countries, for the given savings level, MPK> δ. Thus, k* is below the Golden Rule level of capital, and C* is not maximized. Each country could have higher steadystate consumption by increasing k*(via increased savings).
Real Interest, Nominal Interest and Inflation 20
Percent
15 10
Nominal Interest Rate Inflation Real Interest rate
5
10
20
04 07 20
20
98 01 20
19
92 95 19
19
86 89 19
19
-5
19
19
80 83
0
Year
Comment Since the early 1980s, real interest rates have been in decline. What is notable about the real interest rates in the late 2000s? The notable feature of the real interest rate series is that since 2004s they are low and, for the last couple of years they are almost zero or negative. What might explain the low real interest rates of the last couple of years? Aside from historically low nominal interest rates in order to boost the economy out of recession, the most straightforward explanation for these negative real interest rates is that inflation expectations were consistently too low. Recall that the calculated real interest rates are ex post; that is, they are calculated using actual inflation not the inflation rate that borrowers and lenders expected. If inflation was consistently higher than expected inflation, nominal interest rates would have not fully compensated for the inflation that occurred. One effect of this is to make borrowers better off at the expense of lenders; that is, there is a transfer of resources from lenders to borrowers. Although this seems to be at least part of what happened, it does raise the question as to how people systematically under-predicted inflation. The other explanation for the low real interest rates is that it reflects the equilibrium outcome of saving and investment decisions; for example, low demand for investment would, all else equal, contribute to lower real interest rates.
Q2. a) 6 Marks
Q2 b) 8 Marks i) National savings = Y-C-G = 5000 – 900- 0.6(3000)-1000 = 1300 Investment = 2500- 100(r*) = 2500- 1000 = 1500 NX= S-I = 1300 – 1500 = -200 NX = -200 = 2000- 500 E -> E= 4.4 ii) If r=5, then I = 2500 – (100*5)= 2000 Now, NX = S-I = 1300- 2000 = -700 And -700 = 2000 – 500E -> E=5.4 iii) Graphically,
Q3 a) 4 Marks
Q3 b) 6 Marks
Q4. 20 Marks
In addition, MPK=dy/dk= 0.5k^-0.5 for both countries For Country A: MPK= 0.5(4)^-0.5 = 0.25 And MPK-δ= 0.25-0.05=0.2
For Country B: MPK=0.5*(16)^-0.5=0.125 And MPK- δ=0.125-0.05=0.075 In both countries, for the given savings level, MPK> δ. Thus, k* is below the Golden Rule level of capital, and C* is not maximized. Each country could have higher steadystate consumption by increasing k*(via increased savings).
