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Money, Interest, and Inflation

12. Money, Interest, and Inflation. CHAPTER. CHECKPOINTS. Checkpoint 12.1. Checkpoint 12.2. Checkpoint 12.3. Problem 1. Problem 1. Problem 1. Problem 2. Problem 2. Problem 2. Problem 3. Problem 3. Problem 4. Practice Problem 1 The figure shows the demand for money curve.

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Money, Interest, and Inflation

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  1. 12 Money, Interest, and Inflation CHAPTER CHECKPOINTS

  2. Checkpoint 12.1 Checkpoint 12.2 Checkpoint 12.3 Problem 1 Problem 1 Problem 1 Problem 2 Problem 2 Problem 2 Problem 3 Problem 3 Problem 4

  3. Practice Problem 1 The figure shows the demand for money curve. If the quantity of money is $4 trillion, what is the supply of money and the nominal interest rate? CHECKPOINT 12.1

  4. Solution The supply of money is the curve MS. The interest rate is 4 percent a year, at the intersection of MD1 and MS CHECKPOINT 12.1

  5. Practice Problem 2 The figure shows the demand for money curve. If the quantity of money is $4 trillion and real GDP increases, how will the interest rate change? Explain the process that brings about the change in the interest rate. CHECKPOINT 12.1

  6. Solution An increase in real GDP increases the demand for money. The demand for money curve shifts rightward from MD1 to MD2. At an interest rate of 4 percent a year, people want to hold more money, so they sell bonds. As the supply of bonds increases, the price of a bond falls and the interest rate rises. CHECKPOINT 12.1

  7. Practice Problem 3 If the Fed decreases the quantity of money from $4 trillion to $3.9 trillion, how will bond prices change? Why? CHECKPOINT 12.1

  8. Solution At an interest rate of 4 percent a year, people would like to hold $4 trillion. With only $3.9 trillion of money available, people are holding only $3.9 trillion of money, so they sell bonds. As the supply of bonds increases, the price of a bond falls, and the interest rate rises. CHECKPOINT 12.1

  9. Practice Problem 4 Suppose that banks introduce a user fee on every credit card purchase and increase the interest rate on outstanding credit card balances. How will the demand for money and the nominal interest rate change? CHECKPOINT 12.1

  10. Solution With a fee on each transaction, people will use credit cards less frequently. With a higher interest rate on outstanding balances, the opportunity cost of holding money increases. The demand for money will increase and with no change in the supply of money, the nominal interest rate will rise. CHECKPOINT 12.1

  11. Practice Problem 1 Use the data in the table to calculate the real interest rate. If the real interest rate remains unchanged when the inflation rate increases to 4 percent a year, explain how the nominal interest rate changes. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

  12. Solution The real interest rate equals the nominal interest rate minus the inflation rate. Real interest rate = (6  2) percent a year = 4 percent a year. The nominal interest rate rises from 6 percent a year to 8 percent a year. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

  13. Practice Problem 2 Use the data in the table to calculate the quantity of money in Canada. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

  14. Solution Velocity of circulation (V) = Nominal GDP (P x Y) ÷ Quantity of Money (M). Rewrite this equation as: M = (P x Y) ÷ V. (P x Y) = $866 billion x 1.1 = $975 billion, so M = $975 billion ÷ 10 = $97.5 billion. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10. • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

  15. Practice Problem 3 Use the data in the table. If the quantity of money in Canada grows at 10 percent a year and potential GDP grows at 3 percent a year, what is the inflation rate in the long run? CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

  16. Solution With velocity constant, velocity growth is zero. So in the long run, Inflation rate equals Money growth rate minus Real GDP growth rate Inflation rate = 10 percent a year minus 3 percent a year, which is 7 percent a year. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

  17. Practice Problem 1 Suppose that you have $1,000 in your savings account and the bank pays an interest rate of 5 percent a year. The inflation rate is 3 percent a year. The government taxes the interest that you earn on your deposit at 20 percent. Calculate the nominal after-tax interest rate that you earn. CHECKPOINT 12.3

  18. Solution Your interest income equals 5 percent of $1,000, which is $50. The government takes $10 of your $50 in tax, so the interest income you earn after tax is $40. The nominal after-tax interest rate is ($40 ÷ $1,000) x 100, which equals 4 percent a year. CHECKPOINT 12.3

  19. Practice Problem 2 Suppose that you have $1,000 in your savings account and the bank pays an interest rate of 5 percent a year. The inflation rate is 3 percent a year. The government taxes the interest that you earn on your deposit at 20 percent. Calculate the real after-tax interest rate that you earn. CHECKPOINT 12.3

  20. Solution The real after-tax interest rate equals the nominal after-tax interest rate minus the inflation rate. Your interest income is $50. The government takes $10 of your $50 in tax, so the interest income you earn after tax is $40. The nominal after-tax interest rate is ($40 ÷ $1,000) x 100, which equals 4 percent a year. So the real after-tax interest rate equals 4 percent a year minus the inflation rate of 3 percent a year, which is 1 percent a year. CHECKPOINT 12.3

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