Assessment Questions

Question 1

1. Whenever the inflation rate is below the expected limit, the real interest rate increases to high levels than expected.
2. For instance, the market equilibrium is expected to have a 3% real interest rate whenever marketers expect inflation to hit 4%. As such, the nominal interest rate tends to increase by up to 7%. However, if the inflation rate is 2%, the real interest rate is 5%, which is as a result of subtracting the 7% from the 2% inflation rate.
3. In this case, the real interest rate is beyond the expected limit; thus, the leader tends to gain while the borrower loses.
4. The Global Financial Crisis was characterized by homeowners who had invested in fixed-rate mortgages. However, in the mid-2000s, the homeowners having fixed mortgages lost to pay high-interest rates. On the other hand, banks that have had the mortgages benefited due to the low than expected inflation rates experienced in the markets.
5. Expecting a higher inflation rate provides the best opportunity to align the mortgage rates. However, the difference between the variable rates and fixed rate is expected to be lower than the projected inflation rate. The rate of inflation is expected to be low since high levels lead to an overall increase in the price of commodities.

Question 2

1. Aggregate spending in the given economy is 350 million rubles. Given:

The velocity of money, average number of times a unit of a ruby is exchanged, is seven, and the money supply is fifty million rubles.

As per the quantity theory of money, the level of aggregate nominal expenditure is the product of the velocity of money and quantity of money in the economy. So, the average nominal spending is M*V = 50*7 = 350 million rubles.

1. The velocity of money should rise. The velocity of money and quantity of money is negatively associated with each other; that is, a higher quantity of money leads to a lower value of the velocity of money. In the given problem, people use less money, which requires the velocity to increase so as to carry out the same level of transactions.
2. There should be an increment in the value of velocity due to a lower quantity of money desired by the residents. The introduction of bonds in this economy will act as a substitute for holding money. As a result, residents will hold some income in the form of bonds and desire to hold a lower quantity of money (that is lower money demand), resulting in a higher value of the velocity of money.
3. The given table is:

Based on the above table, the following graph is drawn:

1. The given data backs the quantity theory of money as there is a positive correlation between the average money growth and the rate of inflation in the economy.

As one can also see in the graph that a higher money growth leads to a higher inflation                 rate

Question 3

1. The graph shows a rise in the demand for loanable funds due to the economic crisis, shifts the demand curve for loanable funds from D to D’, S Real interest rate due to which the real interest rate increases.
2. From the graph, it is evident that an upsurge in loanable funds the curve for the loanable funds’ increases in a rightward direction, which creates a situation of excess demand at the given interest rate. It drives the real interest rate upward until the new equilibrium is formed at point e’. At the new equilibrium point, the national savings increases because a rise in the interest rate induces individuals to save more in order to earn higher returns, due to which the quantity of loanable funds increases from Y to Y’. A higher interest rate reduces investment due to an increase in the cost of borrowings.
3. The equilibrium quantities of national savings and investment changes by less than the increase in the demand for loanable funds because a part of the increase in the demand for loanable funds is crowded out due to an increase in the rate of interest, that makes borrowing expensive and reduces the returns on investment.

Question 4                                                                            

1. The pessimism will decrease consumption and investment demand, thus reducing the amount required for aggregate demand. AD curve shifts left, diminishing price level and GDP, thus resulting in a recessionary gap in the short-term.

The graph shown below illustrates the price level labeled P and real GDP, which is depicted as Y and shown vertically and horizontally, respectively. AD0, LRAS0, and SRAS0 are the original cumulative demand, long-run aggregate supply, and short-run aggregate supply curves, which intersects at point A with the original price depicted as level P0 and real GDP-potential GDP as the point Y0. When velocity reduces, AD0 aligns itself to the left of AD1. Moreover, the points intersect SRAS0 at point B with the lesser price level P1 and lower real GDP Y1. As a result, the Recessionary gap is outlined as the gap between Y0 and Y1.

1. To stimulate spending, Central bank should increase the money supply (by the open market purchase of securities and/or by decreasing the required reserve ratio or discount rate). The interest rate reduces due to an increase in the money supply in the markets. As such, investment and aggregate demand increase due to the initiatives adopted by the central bank to increase the money supply in the markets.

To stimulate spending, the government should use expansionary fiscal policy by increasing spending or decreasing tax, both of which will result in an increase in the aggregate demand.

1. In the long run, aggregate demand tends to move back to AD0, ensuring long term equilibrium at point A, thus improving aggregate demand in the markets. Consequently, real GDP restores to potential GDP, and the actual unemployment rate restores the natural unemployment rate. As such, the natural rate of unemployment is thus related to other noble concepts such as potential real GDP and full employment.

Question 5

1. In Ambrosia, wheat sells for 100Ambrosian$ per tonne and for 550bolumbian$ per ton in bolumbian. The exchange rate is 5 BMD per AMD. The situation can be taken advantage of by buying wheat from Ambrosia at 100Ambrosian$ per tonne and selling in bolumbia at 550bolumbian$ per tonne. This 550bolumbian$ can be exchanged for Ambrosian$ by getting 1.1AMD$ (550/100*5). Thus a profit of 0.1AMD$ can be made for every tonne of wheat
2. Profit earned would be 0.1AMD$ per tonne of wheat. (1.1-1.0)
3. If all the people start taking advantage of this opportunity, this would mean that the demand for wheat in AMbrosia would increase, and supply for wheat will increase bolumbia. This would lead to increasing wheat price in Ambrosia and decreasing wheat price in Bolumbia ultimately leading to equal prices for both the countries.
4. Purchasing power parity is based on the Law of one price such that the price of all the identical goods should be similar in countries, and the real exchange rate should reflect no-arbitrage condition. In the long run, if prices remain as given in the question, the real exchange rate would become 5*550/100 = 5.5 BMD per AMD.