Question

The velocity of the money is constant in Gondor. The real GDP is growing at a rate of 5% per year, and the money supply is growing at an annual rate of 14%. The nominal interest rate is 11%. How much is the real interest rate in Gondor?

Answer 1

The real interest rate in Gondor is calculated by subtracting the inflation rate from the nominal interest rate. Considering the constant velocity of money, and the given growth rates of the money supply and real GDP, the real interest rate is 2%.

Step-by-step explanation:

The student is asking about the calculation of the real interest rate in an economy where the velocity of money is constant, real GDP is growing, and the money supply is increasing. To find the real interest rate, we use the Fisher equation, which is real interest rate = nominal interest rate - inflation rate. Since the velocity of money is constant, the increase in money supply will lead to increased nominal GDP by the same percentage, resulting in an inflation rate equal to the difference between the money supply growth and real GDP growth.

Given that the money supply is growing at 14% and real GDP is growing at 5%, the inflation rate would be 14% - 5% = 9%. With a nominal interest rate of 11%, the real interest rate in Gondor would be 11% - 9%, which is 2%.