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Question from Past Macroeconomics Qualifying ExamEdit

Spring, 2004 - Question one - at George Mason University

Interest rates, inflation, and economic growth:

  • a. What is the relationship between the nominal interest rate and the rate of price inflation? Clearly identify the relevant model and evaluate that model in terms of empirical evidence.
  • b. What is the relationship between the real interest rate and economic growth? Clearly identify the relevant model and evaluate that model in terms of empirical evidence.
  • c. What is the relationship between the rate of price inflation and economic growth?

Clearly identify the relevant model and evaluate that model in terms of empirical evidence.

AnswerEdit

  • a. The nominal interest rate is the real rate of interest plus the rate of inflation.
Fisher Identity:  N = R + P (equation 10.3, Romer 2006, p. 499).

The nominal should track some measure of real interest rate and a price adjustment. In the Fisher model it is a one-for-one change, instantaniout.

If there is some nominal rigidity (Keynsian short-run) than this will not always follow. So the real rate will have to take some of the adjustment which will (in a Lucas Island pricing story). This assumes that the rate of growth follows determanistic path and then changes unexpectedly. "The negative effect of monetary espansions on nominal interst rates is known as the liquidity effect." (Rommer 2006, p. 501)

This varies the signal to the entrepreneur and distort the information in the economy (in an Austrian way).

  • b. (Romer 2006, pp. 89-90): Dynamic Efficientcy -> the real rate of return =  f'(k*) - d , where "d" is depreciation.

The real interest rate is the return on capital, the objective discount rate, it also has to equal the subjective discount rate in equilibrium. With the addition of uncertainty, these assumptions do not hold. "If capital earns its marginal product, the net marginal product can be estimated as the ratio of overall capital income minus total depreciation to the value of the capital stock. For the United States, this ratio is about 10 percent, which is much greater than the economy's growth rate. Thus using this approach, we would conclude that the U.S. economy is dynamically efficient. ...Able et al.'s principal empirical result is that the condition for dynamic efficency seems to be satisfied in practice. ...Thus, although decentralized economies can produce dynamically inefficient outcomes in principle, they do not appear to in practice."

  • c. Growth does not determine price inflation directly. It may be the case that growth is correlated with price inflation, in that growth can incorporate an increase in capital per effective worker unit or increased productivity in some other way (thus reflecting cheaper costs of producing). This would be negative price inflation (or deflation).

SourcesEdit

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