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l) The real interest rate r is equal to the nominal interest rate 1' minus the ination rate :r, or r = i It a)

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l) The real interest rate r is equal to the nominal interest rate 1' minus the ination rate :r, or r = i It a) Use this equation to complete the following table. 1 2 3 Real Interest Rate % Nominal Interest Rate % Ination Rate % 10 4 10 8 10 12 4 7 -2 12 3 I N \\0 U1 b) Since the percentage change in P is equal to the rate of ination, this fact suggests that an increase in the rate of money growth of 1 percent causes a 1 percent increase in ination (the quantity theory equation). According to the Fisher equation, this 1 percent increase in ination causes a 1 percent increase in the nominal interest rate 1'. Use all of this information to complete the following Table. 1 2 3 4 5 % Change % Change Ination Real Interest Nominal Interest inP in M Rate 1%! Rate %! Rate 1%! 0 3 0 3 3 4 3 5 3 2 3 8 3 2) a) Because the actual ination rate during a year may be di'erent from the ination rate that was expected at the beginning of the year, the actual real interest rate during that year may turn out to be different from the real interest rate that was expected at the beginning of the year. To account for this difference, a distinction is made between the ex ante real interest rate and the ex post real interest rate. The ex ante real interest rate is the real interest rate that people expected to prevail at the beginning of the year. It is equal to i E 7:, where E Iris equal to the expected rate of ination. After the year ends, however, the rate of inflation is known, and people can calculate the ex post real interest rate that is, the actual real interest rate during the year. The ex post real interest rate is equal to 1' - 7r, where 2: is equal to the actual rate of ination. From this information, one can see that the ex ante real interest rate will equal the ex post real interest rate only if = b) Use the information in Part a to complete the following table. 1 2 3 4 5 Nominal Interest Expected Ex Ante Real Actual Ex Post Real Rate t%! Ination !%2 Interest Rate !%! Ination 1%! Interest Rate t%! 8 3 3 8 3 5 8 3 1 2 1 1

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