Suppose that the nominal prime interest rate for a one-year loan is currently 6 percent.

  1. If inflation is 1 percent per year, what is the current real interest rate? To get full points, you need to show your calculation and explain your answer. (10 points)

  1. Suppose that many people believe that the inflation rate is going to rise in the future – probably up to 2 percent to 3 percent or more within a few years. You want to borrow a sum of money for ten years and are faced with deciding between
    1. A series of short-term, one year loans. The interest rate on this year’s loan would be 6 percent, while future nominal interest rates are unknown.
    2. A ten-year fixed rate loan on which you would pay a constant 6.25 percent per year.

If you agree with most people and expect inflation to rise, which borrowing strategy do you expect might give you the better deal? (5 points)
Why? Explain your reasoning. (10 points)

  1. Suppose that an economy is in deep recession.
    1. Draw and carefully label AS/AD diagram that illustrates this case. (5 points)

  1. Label the point (on your graph above) representing the state of this economy as . (2 points)
  2. If no policy action is taken, what will happen to the economy over time? Show on your graph (draw a new graph below), labeling some new possible equilibrium points , and . (3 points)

(Hint: Think about which curves shifts over time, and why, when the economy stagnates i.e. when there is not sufficient demand for the goods and services produced, and the firms see that they have overproduction and cannot sell most of the products that they have produced. Think about how this can affect the inflationary expectations. Assume there are no changes in investor or consumer confidence or in the economy’s maximum capacity output level).
Explain the shifts that take place. (5 points)