Chapter 34, Problem 2FRQ

a)

To determine

The nominal interest rate if expected inflation is 0%.

Explanation of Solution

The nominal interest rate is the interest rate where inflation would not be considered or simple words when the loan funds are at their lowest without covering inflation, there is a nominal interest rate. On the graph, when the inflation rate is 0% then, the nominal interest rate at this point is 4%

Economics Concept Introduction

Introduction: Inflation means there is an increase in the price of goods and services in the economy which affects the consumption level of the people in the country. And unemployment is the rate of unemployed people who do not have any work or source to employ in the economy. The Philips curve represents that there is a negative or inverse relationship or trade-off between these two factors (inflation and unemployment) in the short run.

b)

To determine

The nominal interest rate if the expected inflation rate were -2%

Explanation of Solution

The nominal interest rate at the expected inflation rate of -2% would be 2% because it cannot be zero or negative but it would be under the optimum quantity of loanable funds according to the given graph. As, on 0% loanable funds, the nominal rate of interest is 4% then, if there is a decrease in the inflation rate to -2% then, the nominal interest rate would be 2%.

Economics Concept Introduction

Introduction: Inflation means there is an increase in the price of goods and services in the economy which affects the consumption level of the people in the country. And unemployment is the rate of unemployed people who do not have any work or source to employ in the economy. The Philips curve represents that there is a negative or inverse relationship or trade-off between these two factors (inflation and unemployment) in the short run.

c)

To determine

The nominal interest rate if the expected inflation rate were -6%

Explanation of Solution

If the expected inflation rate were -6% according to the graph, then the nominal rate of interest would be at any point but it cannot be below zero because banks will not charge less than 0% rate of interest. The nominal interest rate cannot be negative because if banks charge a negative interest rate, then they would pay people to borrow which would not be true. Therefore, at a negative inflation rate, the bank can charge no interest but they will not charge negative interest rates.

Economics Concept Introduction

Introduction: Inflation means there is an increase in the price of goods and services in the economy which affects the consumption level of the people in the country. And unemployment is the rate of unemployed people who do not have any work or source to employ in the economy. The Philips curve represents that there is a negative or inverse relationship or trade-off between these two factors (inflation and unemployment) in the short run.

d)

To determine

The nominal interest rate means to lenders and how much lending will take place at the point of negative nominal interest rate.

Explanation of Solution

At a negative interest rate, lenders will not lend money because they have to pay money to borrowers to lend them. It would increase their costs and therefore, they can lend money at 0 nominal rates of interest but they will not lend money at a negative nominal rate of interest.

Economics Concept Introduction

Introduction: Inflation means there is an increase in the price of goods and services in the economy which affects the consumption level of the people in the country. And unemployment is the rate of unemployed people who do not have any work or source to employ in the economy. The Philips curve represents that there is a negative or inverse relationship or trade-off between these two factors (inflation and unemployment) in the short run.

e)

To determine

The effect of a nominal interest rate of zero on the monetary policy along with the situation.

Explanation of Solution

If the nominal rate of interest is zero then the conventional monetary policy cannot execute because there would be decreasing interest rates and expected inflation would also be considered equal to the negative real rate of interest. It makes the monetary policy ineffective because banks cannot offer money to the borrower through lending as they will not have any incentive to do so. This situation is called deflation because consumers will not spend money for consumption and the supply of money would be affected in the economy.

Economics Concept Introduction

Introduction: Inflation means there is an increase in the price of goods and services in the economy which affects the consumption level of the people in the country. And unemployment is the rate of unemployed people who do not have any work or source to employ in the economy. The Philips curve represents that there is a negative or inverse relationship or trade-off between these two factors (inflation and unemployment) in the short run.