LaunchPad for Krugman's Macroeconomics (Six Month Access)
LaunchPad for Krugman's Macroeconomics (Six Month Access)
4th Edition
ISBN: 9781319011024
Author: Paul Krugman, Robin Wells
Publisher: Worth Publishers
Question
Book Icon
Chapter 10, Problem 10P
To determine

Change in Interest Rate: Interest rate depends on several factors. One such factor is expected inflation rate. The relationship of interest rate and inflation rate is described by the Fisher effect.

Inflation: When the price of any good increases continuously for an interval of time it is called inflation. The formula to calculate inflation rate is:

InflationRate=NominalInterestRateRealInterestRate

Fisher Effect: According to this effect, when there is a rise in the expected inflation rate, then there is always a rise in the nominal interest rate provided loanable fund quantity and interest rate does not change.

Expert Solution & Answer
Check Mark

Answer to Problem 10P

a. When Real inflation Rate is 4%

Given,

Nominal interest rate is 8%.

Real interest is3%.

Expected inflation is 5%.

The formula to calculate real interest rate is:

RealInterestRate=NominalInterestRateInflationRate

Substitute 8% for nominal interest rate and 4% for inflation rate as follows:

RealInterestRate=8%4%=4%

Explanation of Solution

  • If the real inflation is 4%, then it means that the real interest paid by Mr. B is 4%. However, at the initial agreement (expected inflation 5%), he was paying only 3% as real interest.
  • This shows that Mr. B is worse off and Mr. L is better off.

b. When Real inflation Rate is 7%

The formula to calculate real interest rate is:

RealInterestRate=NominalInterestRateInflationRate

Substitute 8% for nominal interest rate and 7% for inflation rate as follows:

RealInterestRate=8%7%=1%

  • If the real inflation is 7%, then it means that real interest paid by Mr. B is 1%. However, at the initial agreement (at 5% expected inflation), he was paying 3% as real interest.
  • This shows that Mr. B is better off and Mr. L is worseoff because now the real interest paid by Mr. B is less than earlier.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!
Knowledge Booster
Background pattern image
Recommended textbooks for you
Text book image
ENGR.ECONOMIC ANALYSIS
Economics
ISBN:9780190931919
Author:NEWNAN
Publisher:Oxford University Press
Text book image
Principles of Economics (12th Edition)
Economics
ISBN:9780134078779
Author:Karl E. Case, Ray C. Fair, Sharon E. Oster
Publisher:PEARSON
Text book image
Engineering Economy (17th Edition)
Economics
ISBN:9780134870069
Author:William G. Sullivan, Elin M. Wicks, C. Patrick Koelling
Publisher:PEARSON
Text book image
Principles of Economics (MindTap Course List)
Economics
ISBN:9781305585126
Author:N. Gregory Mankiw
Publisher:Cengage Learning
Text book image
Managerial Economics: A Problem Solving Approach
Economics
ISBN:9781337106665
Author:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor
Publisher:Cengage Learning
Text book image
Managerial Economics & Business Strategy (Mcgraw-...
Economics
ISBN:9781259290619
Author:Michael Baye, Jeff Prince
Publisher:McGraw-Hill Education