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Econ 110B Ch14 Solutions

Econ 110B Ch14 Solutions - Economics 110B Solutions to...

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Economics 110B Solutions to Practice Questions for Chapter 14 1) Let i = the nominal interest rate and let r = the real interest rate. If an individual borrows one dollar today, the individual is expected to repay 1 + i dollars in the future. Thus, the nominal interest rate represents the cost of borrowing dollars in terms of dollars repaid. Alternatively, if an individual borrows one unit of a good today, the individual is expected to repay 1 + r units of the good in the future. Thus, the real interest rate represents the cost of borrowing goods in terms of goods repaid. 2) The nominal interest rate is determined in financial markets. The real interest rate, r , is e r i π - , where i = nominal interest rate and e π = expected inflation. When i increases, the real interest rate can fall if the increase in expected inflation is greater than the increase in the nominal interest rate. 3) An increase in money growth will cause the LM curve to shift down. This will lower the nominal interest rate. Assuming expected inflation does not change, the real interest rate will fall by the same amount. Investment will increase causing an increase in demand and output. (See graph on page 3 of solutions).
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