Question

1. Please answer all of the following parts:

   1. Please explain the difference between the nominal and real interest rate in the short-run and the long-run. How and why does the quantity theory help us understand the relationship between the money supply, interest rates and inflation?

   2. How and why are nominal interest rates so low in the U.S. today? Please all the tools at your disposal to demonstrate your understanding of the market today.

Answer 1

A)

To understand the difference between nominal interest rate and real interest rate in short run and long run, we need to understand what is nominal interest rate and real interest rate.

Real interest rate is the rate at which the borrowers or lenders (bank and other institutions) receive their cost of funds, also known as their real yield. It removes the effect of inflation and is therefore the real rate of bond.

Nominal interest rate is the rate at which no inflation is taken into account and it is quoted on bonds and loans.

Now, in case of short-run the nominal interest rate is determined through money supply, i.e., when reserve changes the supply of money in the economy, the nominal interest rate changes. For example, if supply increases the interest rate increases as the abundance of money supply should be restricted and vice-versa.

In case of long-run, the interest rate is determined through the real interest rate and inflation. How much is expected of the prices to rise in the long term is the question here.

B) Quantity theory of money indicates how money supply is responsible for inflation and changes in interest rates.To understand this, as discussed earlier, as the reserve changes the money supply there is a change in interest rate and therefor adjustments in inflation. For example- In an economy A, money supply is increasing so in order to control the money supply and to restrict borrowing the banks increase the interest rates and therefore the money supply is regulated. In this economy, the purchasing power decreases because the value of money is decreasing with every unit of money supply that is increasing. The same good x that can cost you 50% less is costing you 50% more and therefore purchasing power decreases which is a result of inflation. Therefore, the theory says that money supply has an impact on the economic activity.

C) Nominal rates are low in U.S.A. due to the Zero Interest Rate Policy. After the great recession, U.S.A.'s financial market dipped by -2.1% and due to which the country adopted ZIRP, it increases employment as well as the consumption power. Although, after ZIRP, U.S.A. continues to grow but Japan is an evidence for detrimental results for long term ZIRP adoption. Due to this policy, the investments increases and therefore leading to increase in employment and consumption power.

Even in this pandemic, the recession is on the peak and therefore the interest rates are low.