1. In the United States of Albion, expected inflation is 5% and the real interest rate is 2%.
(a) What is the nominal interest rate?
(b) If inflation turns out to be 10% instead, what is the ex post real interest rate? Who gains and who loses from this error in forecasting inflation?
(c) Recalculate your answers for (a) and (b) for net interest rates when the tax rate is 50%.
2. The Central Bank of Arcadia has an inflation target of 2%, and forecasts real GDP growth of 2.5% with no change in the velocity of money.
(a) What money supply growth should it target?
(b) If the Central Bank revises its velocity forecast to 3% growth, what does this do to its money supply target?
(c) Assume a forecast of no change in velocity. Interest rates are currently 4%, but inflation is 3% and the money supply is growing at 5.5%. Every 1% increase in interest rates leads to a 1% fall in money supply growth, a 0.5% reduction in output growth, and a 0.25% increase in velocity. What level do interest rates have to be to achieve the 2% inflation target?