1. For this question, assume that the interest rate is greater than 0. Given thi

Question

1. For this question, assume that the interest rate is greater than 0. Given this information and the information about the payments provided below, rank the following three sequences of payments according to their

Select one:

a. A > B > C

b. A > C > B

c. C > B > A

d. C > A > B

2. Suppose the central bank engages in contractionary monetary policy that results in lower money growth. This lower money growth will cause which of the following in the short run?

Select one:

a. lower real interest rates and higher nominal interest rates

b. higher real interest rates and higher nominal interest rates

c. higher real interest rates and lower nominal interest rates

d. no change in either nominal or real interest rates

Explanation / Answer

1. The money that you put into the bank accumulates the value. That means, you'll be getting higher return on a later date from the time you put the money into the bank, the standard case.

So, if you look at the returns provided in the table, you could see that for case A, the value of money is getting increased, whereas for case B, the value is remaining constant and that of for case C is falling over time. This suggests that for case A, interest rate is positive, for B it is zero and for C it is negative.

Therefore, on the basis of interest payment we could write, A > B > C. Option (a) will be our answer.

2. For the Central Bank takes up contractionary monetary policy, the money will get squeezed from the market and accumulates to the bank; that is, the money supply in the market will go down. Now, as the money supply falls, given the demand for loans remaining somewhat constant, the nominal rate of interest will increase as banks will now be demanding higher interest rate for the loans they provide. Simply, we could think of it as demand for loans remaining the same, and the supply of loanable funds are reduced, which increases the price (the nominal interest rate) of the loans provided by the commercial banks.

Now, with the increase in interest rate, the investment siege to fall, which in turn leads to reduction in the GDP, and if we assume that the aggregate demand remains the same, the reduction in GDP will reflect in the rise in the price level, leading to a inflationary situation. If the rate of growth of nominal interest rate exceeds the rate of inflation, then we could say that the real interest rate will be increasing and vice-versa.

Since in simplistic economic analysis, the distinction between nominal and real interest rate is not made when looking at the effects of fiscal and monetary policy, we could say that both the real and nominal interest rate will rise in case of contractionary monetary policy. So, option (b) will be our answer.

Although even if the rise in nominal interest rate is evident, the actual change (increase or decrease) in the real interest rate should be looked based on the relative change in the nominal interest rate and inflation level.

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