1. The expected real rate of interest is the nominal interest rate minus the expected inflation rate. ____________(True/False)
2. Countries with higher rates of money growth have____________ interest rates.
3. If the growth rate of money increases from 3 to 5 percent, initially interest rates will ____________.
4. A firm that expects higher profits from higher prices but does not recognize its costs are increasing is suffering from____________.
5. Inflation: A Recipe for Japan? In the late 1990s, Japan s economy was still in a prolonged slump. Nominal interest rates were approximately zero, which many economists believed limited the scope for monetary policy. Professor Paul Krugman of Princeton University, and a Nobel Laureate, disagreed. He argued that Japan s central bank should increase the money supply rapidly with the intention of causing inflation. Moreover, it should credibly promise to continue this inflation policy into the future. The result, he predicted, would be increased investment and higher GDP growth. Krugman’s recommendation was based on the distinction between real and nominal interest rates. Can you explain his logic?
6. Money Neutrality, Long Run Inflation, and the Natural Rate. Explain carefully the relationship between the concept of monetary neutrality and the idea that the natural rate is independent of the long run inflation rate.
7. Taxes, Inflation, and Interest Rates. If a business borrows funds at 10 percent per year, the business has a 40 percent tax rate, and the annual inflation rate is 5 percent, what are the real after-tax costs of funds to the business? Similarly, if an investor receives a nominal return of 8 percent on a savings deposit, the tax rate is 30 percent, and the inflation rate is 6 percent, what is the after-tax rate of return?
8. Examples of Money Illusion. What do the following two quotes have in common?
a. My wages are going up 5 percent a year. If only inflation weren’t 5 percent a year, I would be rich.
b. My bank is paying 10 percent a year, but the 8 percent inflation rate is just eating up all my real investment gains.