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Money, Interest,
and Inflation
28
CHECKPOINTS
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Click on the button to go to the problem
Checkpoint 28.1
Checkpoint 28.2
Checkpoint 28.3
Problem 1
Problem 1
Problem 1
Problem 2
Problem 2
Problem 2
Problem 3
Problem 3
Problem 4
In the news
In the news
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CHECKPOINT 28.1
Practice Problem 1
The figure shows the
demand for money curve.
If the quantity of money is
$4 trillion, what is the supply
of money and the nominal
interest rate?
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CHECKPOINT 28.1
Solution
The supply of money is the
curve MS.
The interest rate is 4 percent
a year, at the intersection of
MD1 and MS.
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CHECKPOINT 28.1
Practice Problem 2
The figure shows the
demand for money curve.
If the quantity of money is
$4 trillion and real GDP
increases, how will the
interest rate change?
Explain the process that
brings about the change in
the interest rate.
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CHECKPOINT 28.1
Solution
An increase in real GDP
increases the demand for money.
The demand for money curve
shifts rightward from MD1 to MD2.
At an interest rate of 4 percent a
year, people want to hold more
money, so they sell bonds.
As the supply of bonds increases,
the price of a bond falls and the
interest rate rises.
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CHECKPOINT 28.1
Practice Problem 3
If the Fed decreases the
quantity of money from
$4.0 trillion to $3.9 trillion,
how will bond prices
change? Why?
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CHECKPOINT 28.1
Solution
At an interest rate of 4 percent
a year, people would like to
hold $4.0 trillion.
With only $3.9 trillion of money
available, people are holding
only $3.9 trillion of money, so
they sell some bonds.
As the supply of bonds
increases, the price of a bond
falls, and the interest rate rises.
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CHECKPOINT 28.1
Practice Problem 4
If banks increase the interest rate they pay on deposits,
how will the demand for money and the nominal interest
rate change?
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CHECKPOINT 28.1
Solution
The higher interest rate on bank
deposits lowers the opportunity
cost of holding money, so the
demand for money increases.
As the demand for money
increases, with no change in the
supply of money, the nominal
interest rate in the money market
will rise.
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CHECKPOINT 28.1
In the news
What to do with $50,000 now
A good strategy: Put about two-thirds of the money into
bonds of developed nations and put the rest into a riskier
emerging market bond fund.
Source: CNNMoney.com
What is the opportunity cost of holding money?
If lots of people followed this advice and put their money
into bonds, how will the demand for money and the
interest rate change?
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CHECKPOINT 28.1
Solution
The opportunity cost of holding money is the highest
interest rate forgone by not holding bonds.
As lots of people decide to buy bonds, the demand for
money decreases.
The decrease in the demand for money, with no change
in the supply of money, lower the interest rate on bonds.
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CHECKPOINT 28.2
Practice Problem 1
Use the data in the table to
calculate the real interest
rate.
In 1999, the Canadian
economy at full employment.
• Real GDP was $886 billion.
• The nominal interest rate was
If the real interest rate
remains unchanged when the
inflation rate increases to 4
percent a year and then
remains constant, explain
how the nominal interest rate
changes in the long run.
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around 6 percent per year.
• The inflation rate was 2
percent a year.
• The price level was 1.1.
• The velocity of circulation was
constant at 10.
CHECKPOINT 28.2
Solution
The real interest rate equals
the nominal interest rate
minus the inflation rate.
In 1999, the Canadian
economy at full employment.
Real interest rate = (6  2)
percent a year = 4 percent a
year.
• The nominal interest rate was
The nominal interest rate
rises from 6 percent a year
to 8 percent a year.
• The price level was 1.1.
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• Real GDP was $886 billion.
around 6 percent per year.
• The inflation rate was 2
percent a year.
• The velocity of circulation was
constant at 10.
CHECKPOINT 28.2
Practice Problem 2
Use the data in the table to
calculate the quantity of
money in Canada.
In 1999, the Canadian
economy at full employment.
• Real GDP was $886 billion.
• The nominal interest rate was
around 6 percent per year.
• The inflation rate was 2
percent a year.
• The price level was 1.1.
• The velocity of circulation
was constant at 10.
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CHECKPOINT 28.2
Solution
Velocity of circulation (V) equals
Nominal GDP (P x Y) divided by
Quantity of Money (M).
Rewrite this equation as:
M = (P x Y) ÷ V.
(P x Y) = $866 billion × 1.1
= $975 billion,
so M = $975 billion ÷ 10
= $97.5 billion.
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In 1999, the Canadian
economy at full employment.
• Real GDP was $886 billion.
• The nominal interest rate was
around 6 percent per year.
• The inflation rate was 2
percent a year.
• The price level was 1.1.
• The velocity of circulation was
constant at 10.
CHECKPOINT 28.2
Practice Problem 3
Use the data in the table.
If the quantity of money in
Canada grows at 10 percent
a year and potential GDP
grows at 3 percent a year,
what is the inflation rate in the
long run?
In 1999, the Canadian
economy at full employment.
• Real GDP was $886 billion.
• The nominal interest rate was
around 6 percent per year.
• The inflation rate was 2
percent a year.
• The price level was 1.1.
• The velocity of circulation was
constant at 10.
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CHECKPOINT 28.2
Solution
With velocity constant, velocity
growth is zero.
So in the long run,
In 1999, the Canadian
economy at full employment.
• Real GDP was $886 billion.
• The nominal interest rate was
around 6 percent per year.
Inflation rate equals Money
growth rate minus Real GDP
growth rate.
Inflation rate = 10 percent a
year minus 3 percent a year,
which is 7 percent a year.
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• The inflation rate was 2
percent a year.
• The price level was 1.1.
• The velocity of circulation was
constant at 10.
CHECKPOINT 28.2
In the news
“The U.S. can pay any debt because we can always print
more money.”
Source: Meet the Press, August 7, 2011
Explain why “always printing money” will “pay off the debt.”
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CHECKPOINT 28.2
Solution
“Printing money” means the Fed increases the quantity of
money by buying government bonds. This transaction
doesn’t “pay off the debt.” It merely transfers the debt to
the Fed.
But at full employment and a given velocity of circulation,
when the Fed increases the quantity of money, the price
level rises (the quantity theory of money).
The higher price level lowers the real value of the debt.
That is how “printing money” ends up “paying off the
debt.”
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CHECKPOINT 28.3
Practice Problem 1
Ben has $1,000 in his savings account and the bank pays
an interest rate of 5 percent a year.
The inflation rate is 3 percent a year.
The government taxes the interest that Ben earns on his
deposit at 20 percent.
Calculate the after-tax nominal interest rate and the after-tx
real interest rate that Ben earns.
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CHECKPOINT 28.3
Solution
Ben’s interest income equals 5 percent of $1,000, which is
$50.
The government takes $10 of his $50 in tax, so the interest
income he earns after tax is $40.
The nominal after-tax interest rate is ($40 ÷ $1,000) ×
100, which equals 4 percent a year.
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CHECKPOINT 28.3
The after-tax real interest rate equals the after-tax nominal
interest rate minus the inflation rate.
The after-tax nominal interest rate is 4 percent a year.
So the after-tax real interest rate equals 4 percent a year
minus the inflation rate of 3 percent a year, which is 1
percent a year.
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CHECKPOINT 28.3
Practice Problem 2
Inflation-adjusted savings bonds hit 0% rate
Inflation-adjusted savings bonds purchased from May
through October 2009 will earn 0% for the first six months.
The fixed interest rate on these bonds is 0.1% and over
the previous 6 months, inflation fell at an annual rate of
5.56%. The minimum interest rate on savings bonds is set
at 0%.
Source: USA Today, May 5, 2009
Are these savings bonds a better deal than cash under the
mattress?
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CHECKPOINT 28.3
Solution
At 0 percent interest rate, these bonds are just as good a
deal as cash under the mattress.
But if inflation starts to rise as the economy recovers from
recession, the nominal interest rate will exceed 0.1
percent.
The real interest rate will be certain and equal 0.1 percent
a year—a better deal than cash.
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