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AP3Macro_Unit4HWReview

The document explains the relationship between nominal interest rates, real interest rates, and inflation using the Fisher equation. It discusses how increased government deficit spending raises the supply of bonds, leading to lower bond prices and higher real interest rates. Additionally, it highlights the impact of increased government spending on money demand and nominal interest rates, as well as the differences between bonds and stocks.

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AP3Macro_Unit4HWReview

The document explains the relationship between nominal interest rates, real interest rates, and inflation using the Fisher equation. It discusses how increased government deficit spending raises the supply of bonds, leading to lower bond prices and higher real interest rates. Additionally, it highlights the impact of increased government spending on money demand and nominal interest rates, as well as the differences between bonds and stocks.

Uploaded by

Јелена Ј.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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1.

To find the expected real interest rate, you can use the Fisher equation, which relates
nominal interest rates, real interest rates, and inflation rates. The equation is:
(1+i)= (1 + r) x (1+ π)
Where:
 i is the nominal interest rate,
 r is the real interest rate,
 π is the inflation rate.
In this case:
 The nominal interest rate is 5% or 0.05,
 The expected inflation rate π is 2% or 0.02.
Rearranging the Fisher equation to solve for r, we get:

1 +r = 1+I / 1+ π

1+r = 1+0.05/ 1+0.02

1+r=1.05/1.03

1+r=1.0294 (or we round up to 1.03)

r=1.03-1= 0.3 or 3 percent


2.

BONDS PRICE DECREASE


REAL INTEREST RATE INCREASE
Explanation:
Bond Prices and Supply: When the government increases deficit spending, it needs to
raise more funds by issuing additional bonds. This increased supply of bonds puts
downward pressure on the prices of existing bonds because there are now more bonds
available in the market. As bond prices fall, their yields (interest rates) rise to match the
new bonds being issued at higher rates.
Interest Rates and Borrowing Costs: The higher supply of bonds causes nominal
interest rates to rise. This rise in nominal rates reflects the increased cost of borrowing
for the government. Investors demand a higher return to compensate for the greater
supply of bonds and potential future inflation.
Real Interest Rates: Real interest rates are calculated by subtracting expected inflation
from the nominal interest rate. If the nominal interest rate increases (due to higher
supply and borrowing costs) and inflation expectations remain unchanged, the real
interest rate will increase as well.
In summary, increased government deficit spending leads to a higher supply of
bonds, which causes the price of existing bonds to fall and the real interest rates
to rise, reflecting the higher cost of borrowing and adjusting for inflation.
3.

This is the example we worked on in class on August 6. Here are the board notes to
review:
4.

In summary, increased government spending can lead to higher economic activity and
transaction volumes, which raises the demand for money. If the central bank does not
increase the money supply to match this higher demand, nominal interest rates will rise
as a result of the increased demand for money.
Increased government spending= drives demand for money up. So if the central bank
does not create more money, they will become scarce due to increased demand and
the law of demand will push “price” of money up, that is, the nominal interest rates.
5.

EXPLANATION:
Bond Prices: When the government increases borrowing, it issues more bonds. This
higher supply lowers the price of existing bonds because new bonds are issued at
higher interest rates, making older bonds with lower rates less attractive.
Price Level: In the short run, increased government borrowing can lead to higher
demand in the economy (more spending). This boost in demand can push up the overall
price level (inflation) as more money chases the same amount of goods and services.

6.

Bonds are interest-bearing because they are a form of debt. When you buy a bond,
you're essentially lending money to the issuer (like a government or corporation) in
exchange for periodic interest payments (coupons) and the return of the principal at
maturity.
Stocks, on the other hand, represent ownership in a company. Shareholders have a
claim on the company's profits but do not receive fixed payments. Instead, they may
receive dividends, which are variable and depend on the company's performance and
decisions made by its board.

7.

To find the real interest rate, use the Fisher equation:

Real Interest Rate=Nominal Interest Rate−Inflation Rate= 10%-5%= 5%

8.
A barter economy has higher transaction costs because:
1. Double Coincidence of Wants: In barter, both parties must want what the other
has to offer, which complicates and slows down transactions.
2. Lack of Standardized Measure: Without a common medium, it’s harder to
determine value and negotiate trades efficiently.
3. Increased Time and Effort: Finding suitable trading partners and negotiating
each transaction is time-consuming and labor-intensive.
In contrast, a monetary economy uses money as a common medium of exchange,
reducing these transaction costs significantly.

9.

This is also an example we solved in class, here are the notes for review:
10.

C) An increase in the real interest rate is the correct choice because:


 Real Interest Rate Increase: Higher real interest rates make borrowing more
expensive, which reduces investment. This shifts the investment demand curve
to the left, not to the right.
Why the others are not correct:
 A) A decrease in the corporate income tax rate: Lowers tax burdens on
profits, increasing after-tax returns on investments, which shifts the investment
demand curve to the right.
 B) An increase in the productivity of new capital goods: Makes new
investments more profitable, encouraging more investment, which shifts the
demand curve to the right.
 D) An increase in corporate profits: Provides more funds available for
investment and signals better profitability, shifting the demand curve to the right.
 E) An increase in real GDP: Indicates higher economic activity and potential for
greater returns on investment, shifting the investment demand curve to the right.
In summary, the third option is the correct answer as it is the only scenario where we
have a negative shift, while all others represent a positive shift.

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