Suppose in Country A, the velocity of money is constant. Real GDP grows by 5 per cent per year, the money stock grows by 10 per cent per year, and the nominal interest rate is 8 per cent. What is the inflation rate and real interest rate?
Question
Suppose in Country A, the velocity of money is constant. Real GDP grows by 5 per cent per year, the money stock grows by 10 per cent per year, and the nominal interest rate is 8 per cent. What is the inflation rate and real interest rate?
Solution
The inflation rate and real interest rate can be calculated using the Quantity Theory of Money and the Fisher Equation.
The Quantity Theory of Money states that the money supply times the velocity of money equals the price level times real GDP. If the velocity of money is constant, then the growth rate of the money supply equals the inflation rate plus the growth rate of real GDP.
So, if real GDP grows by 5% per year and the money stock grows by 10% per year, the inflation rate can be calculated as:
Inflation Rate = Growth Rate of Money Supply - Growth Rate of Real GDP Inflation Rate = 10% - 5% = 5%
The Fisher Equation states that the nominal interest rate equals the real interest rate plus the inflation rate. We can rearrange this to solve for the real interest rate:
Real Interest Rate = Nominal Interest Rate - Inflation Rate Real Interest Rate = 8% - 5% = 3%
So, the inflation rate in Country A is 5% and the real interest rate is 3%.
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