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# ps7ans - ECON 305: INTERMEDIATE MACROECONOMICS SPRING 2011...

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ECON 305: INTERMEDIATE MACROECONOMICS SPRING 2011 MARK MOORE PROBLEM SET 7 SOLUTIONS A. CHAPTER 14 Quick Check 1. a. True. b. True. c. True. d. False. e. True. f. False. g. True. h. True. The nominal interest rate is always positive. i. False. The real interest rate can be negative. 2. a. Real. Nominal profits are likely to move with inflation; real profits are easier to forecast. b. Nominal. The payments are nominal. c. Nominal. Car lease and car loan payments are usually stated in nominal terms. 3. a. exact: r = (1+.04)/(1+.02)-1 = 1.96%; approximation: r .04-.02 = 2% b. 3.60%; 4% c. 5.48%; 8% 4. a. No. If the nominal interest rate were negative, nobody would hold bonds. Money would be more appealing since it could be used for transactions and would earn zero—as opposed to negative—interest. b. Yes. The real interest rate is negative if expected inflation exceeds the nominal interest rate. Even in this case, the real interest rate on bonds (which pay nominal interest) exceeds the real interest rate on money (which does not pay nominal interest) by the nominal interest rate. b. A negative real interest rate makes borrowing very attractive and leads to a large demand for investment.

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c. Answers will vary. 5. a. The discount rate is the interest rate. So, in case (i), the EPDV is \$2,000(1-0.25) under either interest rate, and in case (ii) the EPDV is (1- 0.2)\$2,000 under either interest rate. b. The interest rate does not enter the calculation. Hence, you prefer (ii) to (i) since 20%<25%. Note that the answer to part (a) does not imply that saving will not accumulate. By retirement, the initial investment will have grown by a factor of (1+i) 40 in nominal terms and (1+r) 40 in real terms. As long as r is positive, the purchasing power of the initial investment will grow. Moreover, this problem assumes that the tax rate you will pay upon retirement (25%) is higher than the tax rate you pay when you establish the IRA (20%). This assumption may be false for some taxpayers. 6. a. \$ V =\$100/0.1=\$1000 b. Since the first payment occurs at the end of the year, \$ V = \$ z [1- 1/(1+ i ) n+1 ]/[1-1/(1+ i )] - \$ z , where n is the years to maturity of the bond 10 years: \$614.46; 20 years: \$851.36; 30 years: \$942.69; 60 years: \$996.72 c. i = 2%: PV of consol=\$5000; 10 years: \$898.26; 20 years: \$1635.14; 30 years: \$2239.65; 60 years: \$3476.09 i = 5%: PV of consol=\$2000; 10 years: \$772.17; 20 years: \$1246.22; 30 years: \$1537.25; 60 years: \$1892.93 7. a. The Fisher hypothesis is that in the medium run, changes in inflation are reflected one- for-one in changes in the nominal interest rate. In other words, in the medium run, changes in inflation have no effect on the real interest rate.
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## This note was uploaded on 05/26/2011 for the course ECON 305 taught by Professor Dekle during the Spring '07 term at USC.

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ps7ans - ECON 305: INTERMEDIATE MACROECONOMICS SPRING 2011...

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