Assignment 2

Assignment 2

1. Complete the following table:
Real interest rate(%)         Nominal interest rate(%)     Inflation rate(%)
…………                                            10                                   4
4                                                   7                                  …….
-2                                                   12                                ……..
3                                                    ……..                                 5

2. Complete the following table:
Nominal interest rate    Expected inflation  Ex-ante Real i   Actual Inflation  ExPost Real i
8                                           3                            ……                    3                       ……
8                                            3                            …….                   5                       ……
2                                            -1                          ……….                 1                      ……..
(a)    When actual inflation is equal to expected inflation, the ex post real interest rate is ……………… than the ex ante real interest rate.
(b)    When actual inflation is less than expected, the ex post real interest rate is …….. than the ex ante real interest rate.

3. Say Tom buys a new house for $300,000 and takes a mortgage loan equal to the full amount at 7 percent interest rate. We will assume that the home’s value will increase at the rate of inflation. If the expected rate of inflation is 4% the home is expected to increase in value by $……. each year. What is the expected real cost of the mortgage each year? Expressed as a % of the initial loan, this amount equals …….. percent. What is the expected real cost of the mortgage?
4    One specific money demand function that fits Canadian data fairly well is:
(M/P)d = i -0.1  Y. Now answer the following questions.
•    If real output and nominal interest rate are 100 and 3 respectively, what is the quantity of real money demanded?
•    Say, people assume that the central bank will soon increase the nominal money supply by 5 percent. According to the Fisher equation, what will be the nominal interest rate? If real output remains constant, what will be the quantity of real money demanded?

5    In Canada, people pay personal income taxes on nominal interest income and nominal capital gains. If the real interest rate is 2% and inflation is 4%, what is the nominal interest rate? Now, consider a family that pays a marginal tax rate of 33.33 percent. This family therefore earns a after-tax nominal interest rate of …….. percent. What is the family’s after-tax real interest rate?

6    Consider a monetary policy of zero inflation. Given how inflation is treated by the Canadian Tax Code, explain: (a) the effect on savings and investment when both actual and expected inflation are zero;  (b) if the long run annual rate of growth of output is 3%, use the Quantity equation to calculate the approximate growth rate of money supply.