Reading 25: U.S. Inflation, Unemployment, and Business Cycles following, 2010, increase, Business

honeycfa

LOS d: Explain the relation among inflation, nominal interest rates, and the demand and supply of money.

 

Which of the following is least likely to result from an increase in the rate of growth in the money supply?

A) A higher real risk-free rate.

B) Higher actual inflation.

C) A higher nominal risk-free rate.

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The real risk-free rate is independent of changes in the growth of the money supply. Both remaining items are consistent with an increase in the growth rate of the money supply.

 

honeycfa

Two economists, Pearl Millidge and Byron Forrest, are discussing theories that explain why increased inflation causes nominal interest rates to rise. They offer the following explanations:

Millidge: Because businesses expect higher prices for their output in the future, they will expect a greater return on their investments and will increase their demand for financial capital, which will drive interest rates higher.

Forrest: Savers expect to pay higher prices for goods and services in the future, so they will be less willing to trade current consumption for future consumption and will therefore supply less financial capital, so interest rates increase.

Are these explanations CORRECT?

Millidge

Forrest

A) Correct Correct

B) Incorrect Correct

C) Correct Incorrect

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Both explanations are correct. Higher inflation results in increased demand for financial capital and decreased supply of financial capital. Both cause nominal interest rates to increase.

honeycfa

If market participants come to believe that the expected inflation rate embedded in the current nominal risk-free rate of interest is less than will actually occur, this will have the effect of:

A) increasing demand for funds and decreasing the supply until the nominal risk-free rate increases to reflect the new expectations.

B) increasing demand for funds and decreasing the supply until the nominal risk-free rate decreases to reflect the new expectations.

C) decreasing demand for funds and increasing the supply until the nominal risk-free rate increases to reflect the new expectations.

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If market participants come to believe that actual inflation will be greater than the expected inflation premium embedded in the nominal risk-free rate, the demand for financial capital will increase, the supply will decrease, and, eventually, the nominal risk-free rate will increase to reflect the new expectations.

honeycfa

The nominal risk-free rate of interest equals the real risk-free rate:

A) plus actual inflation.

B) plus expected inflation.

C) minus expected inflation.

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The nominal risk-free rate of interest (i.e., that which is observed as the required rate of return on T-bills) equals the real risk-free rate plus expected inflation.