Question 3: Interest Rates and Inflation (4 points)
a. Define the Fisher equation and derive the relationship between real and nominal
interest rates algebraically. Also explain how expected inflation affects lending
and borrowing decisions. (2 pts)
b. Suppose the nominal interest rate is 6% and expected inflation is 4%. What is the
ex-ante real interest rate? (1 pt)
c. If actual inflation turns out to be 7%, who gains and who loses? Provide an
example of each. (1 pt)
Question 4: (4 points)
a. List and explain two important costs of inflation. For one of them, explain how this
cost could be modeled or illustrated in an economic diagram. (2 pts)
b. Explain how inflation can distort relative prices. Use an example to show why this
distortion might lead to inefficient economic decisions. (1 pt)
c. Briefly explain a potential unintended consequence of using price controls to fight
inflation, using Nixon's wage-price controls as an example. (1 pt)