Assignment 2.docx

In the short run banks control of the nominal

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In the short run banks' control of the nominal interest rate allows it to control the ex- ante real interest rate as well. Equilibrium output is determined by the real interest rate real interest rate, and, the AE curve. 3. Three-month rate = 3% + three-month term premium Six-month rate = (3% + 3.5%)/2 = 3.25% + six-month term premium One-year rate = (3/12)3% + (9/12)3.5% = 3.375% + one-year term premium. 4. Given that Both countries have the same money growth rate and same constant real output In country A, velocity is constant, In country B, velocity has fallen Therefore, inflation will be higher in country A. We can determine which country will face higher inflation by using the formula: Money Growth + Velocity Growth = Inflation + Real Growth By using the above formula, we know as the velocity growth and remaining rates in Country A are constant. Inflation also constant while velocity growth in Country B has fallen. But money growth and real growth constant inflation also will have fallen. Therefore, inflation will certainly be higher in Country A.

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5. Deflation means sustained fall in general price level. Deflation makes the situation of liquidity trap worse. Liquidity occurs where rise in money supply no longer able to
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• Fall '12
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