Question 1
a) You put money into an account that earns a 5 percent nominal interest rate. Theinflation rate is 3 percent, and your marginal tax rate is 20 percent. What is your after-tax real rate of interest?
b) Suppose that changes in bank regulations expand the availability of credit cards so that people need to hold less cash. How does this event affect the demand for money? What is the impact on the price level? If the Fed wants to keep the price level stable, what should it do? Draw money demand and money supply diagram to explain. Label the diagram clearly.
c) If the money supply is growing at a rate of 6 percent per year, real GDP is growing at a rate of 3 percent per year, and velocity is constant, what will the inflation rate be? If velocity is increasing 1 percent per year instead of remaining constant, what will the inflation rate be?
Question 2
a) The economy is in a recession with high unemployment and low output. Use a graph of aggregate demand and aggregate supply (AD-AS diagram) to illustrate the current situation. Be sure to include the aggregate demand curve, the short-run aggregate supply curve, and the long-run aggregate supply curve. Now, suppose the Fed expands the money supply to help the economy to recover from the recession. Using AD-AS diagram, show how it will help the economy to get back to the long-run equilibrium.
b) A student was asked to draw an AD-AS graph to illustrate the effect of an increase in aggregate supply. The student drew the following graph.
The student explains the graph as follows:
"An increase in aggregate supply cause a shift from SRAS1 to SRAS2. Because this shift in the aggregate supply curve results in a lower price level, consumption, investment, and net exports will increase. The change causes the aggregate demand curve to shift to the right, from AD1 to AD2. We know that real GDP will increase, but we can't be sure whether the price level will rise or fall because that depends on whether the aggregate supply curve or the aggregate demand curve has shifted further to the right. I assume that aggregate supply shifts out farther than aggregate demand, so I show the final price level, P3, as being lower than the initial price level, P1"
Explain whether you agree with the student's analysis. Be careful to explain exactly what- if anything-you find wrong with this analysis.