Suppose the interest rate is zero and the public expects the price level to fall by 2%. Which of the following statement is true?
A) The value of money falls by 2%.
B) Money becomes an interest earning asset; it earns a nominal interest rate of 2%.
C) Money becomes an interest earning asset; it earns a real interest rate of 2%.
D) Bonds and money will become perfect substitutes since both are non-interest earning assets.

Question

Quizplus · Accepted Answer

When the public expects the price level to fall by 2%, the real value of money increases by 2% (since the same amount of money can purchase more goods). With zero nominal interest rate, the real interest rate is also zero. Therefore, the nominal and real interest rates are both 0%, and money does not become an interest earning asset. Bonds and money are not perfect substitutes since bonds are interest earning assets while money is not.

Suppose the Interest Rate Is Zero and the Public Expects