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In the country of Winterfell, the velocity of money is constant. GDP growth is 4% per year, the money stock grows at 14% per year, and the nominal interest rate is 11%. What is the real interest rate?

Question

In the country of Winterfell, the velocity of money is constant. GDP growth is 4% per year, the money stock grows at 14% per year, and the nominal interest rate is 11%. What is the real interest rate?

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Solution

To calculate the real interest rate, we need to use the Fisher equation, which states that the real interest rate is approximately equal to the nominal interest rate minus the inflation rate.

In this case, the nominal interest rate is given as 11%.

The inflation rate can be calculated using the Quantity Theory of Money, which states that the money supply times the velocity of money equals the price level times the real GDP. In this case, we are told that the velocity of money is constant, so changes in the money supply will lead to proportional changes in the price level (i.e., the inflation rate).

We are told that the money stock grows at 14% per year and the GDP growth is 4% per year. Therefore, the inflation rate is the growth rate of the money supply minus the growth rate of real GDP, or 14% - 4% = 10%.

Therefore, the real interest rate is the nominal interest rate minus the inflation rate, or 11% - 10% = 1%.

This problem has been solved

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