**3 Inflation and expected inflation are important determinants of economic activity.**

**(a) Draw a CLG of the short-run Phillips curve.**

You should know how to do this without thinking,,,

Phillips Curve, a tradeoff between inflation and employment

Unemployment & Inflation Cheat Sheet -

Short-Run Phillips curve downward sloping with axis labeled appropriately.

**(b) Using your graph is part (a), show the effect of an increase in the**

*expected*rate of inflation.*Expected Inflation not actual inflation*

**(c) What is the effect on the increase in the**

*expected*inflation rate on the Long-Run Phillips curve.

The long-run phillips curve is effected by situations that will decrease or increase the

*NRU, Natural Rate of Unemployment,*,, so if the government expand unemployment benefits the LRPC will shift right,, and if the government cuts unemployment benefits the LRPC will shift left.

**There is no trade-off between unemployment and inflation in the Long-Run.**

__Answer - an increase in the expected rate of inflation does not effect the LRPC.__

**(d) Given the expectation of the increase in inflation from part (b)**

**(i) will the nominal interest rates on new loans increase, decrease or remain unchanged?**

If inflation is expected to increase then the Price Level is expected to increase then the demand for money is expected to increase.. If demand for money is expected to increase then interest rates for new loans will increase.

__Answer - Nominal interest rates will increase.__

**(ii) Will the real interest rate on new loans, increase, decrease, or remain unchanged?**

Ok, so if the nominal interest rate is rising with the expected level of inflation the bankers crafting new loans will be building into the loans the expected rise in inflation.

In essence,, I'm a banker and I'm selling loans at the nominal rate of interest of 5% and this is also the real rate with no inflation,,,

**but**I expect the rate of inflation to increase by 2%,,, I'm going to sell all new loans at 7% rates of interest. I'm going to build into the loans the expected rate (2%) of inflation. Thus the real rate will not change it will still be 5%.
Nominal Rate = Real Rate (no inflation)

Real Rate = Nominal Rate - Inflation

Nominal Rate = Real Rate + inflation

__Answer - The real interest rate will not change__

**(e) Assume that the nominal interest rate is 8%. Borrowers and lenders expect the rate of inflation to be 3% and the growth rate of the real GDP is 4%. Calculate the real interest rate.**

**Real Rate = Nominal Rate - Inflation**

**5% = 8% - 3%**

__Answer - the real interest rate is 5%__