According to the quantity theory of money and the Fisher equation, if the money growth increases by 4 percent and the real interest rate equals 2 percent, then the nominal interest rate will _____ by _____ percent.
Select one:
A.increase; 2
B.increase; 3
C.increase; 5
D.increase; 6
E.
decrease; 3
F.
decrease; 2
According to the Quantity Theory of Money and the Fisher Equation, changes in the money supply can have an impact on nominal interest rates. The Quantity Theory of Money posits that the quantity of money in circulation has a direct relationship with the price level in the economy. The Fisher Equation, on the other hand, relates nominal interest rates (i) to real interest rates (r) and the expected inflation rate (π), and it is expressed as:
�=�+�
In this case, we are given that the money growth rate is increasing by 4 percent, and the real interest rate is 2 percent. Let’s break down the possible effects on the nominal interest rate:
Increase in Money Growth Rate: When the money supply increases, it tends to put upward pressure on prices due to the Quantity Theory of Money. This is because there is more money chasing the same amount of goods and services, which can lead to inflationary pressures.
Real Interest Rate: The real interest rate is the rate at which borrowers and lenders exchange funds in terms of purchasing power, adjusted for inflation. In this case, the real interest rate is 2 percent.
Expected Inflation Rate (π): To find the expected inflation rate, we can subtract the real interest rate (2 percent) from the nominal interest rate (i) once we calculate it.
Now, let’s calculate the nominal interest rate using the Fisher Equation:
�=�+� �=2
Since we know that the money growth rate is increasing by 4 percent, we can reasonably expect that the inflation rate will also increase by a similar percentage due to the Quantity Theory of Money. Therefore, the expected inflation rate (π) is 4 percent.
Now, we can calculate the nominal interest rate:
�=2
So, the nominal interest rate will increase by 6 percent. Therefore, the correct answer is option D: “increase; 6.”
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