Question 4 (13 marks)

(a)What is "hyperinflation"? Explain how it could happen using the quantity equation.

(4 marks)

(b)Jack and King each earn a real interest rate of 4% from their savings account. However, Jack lives in a country with a 2% inflation rate, while King lives in a country with a 8% inflation rate. Both countries have a 20% tax on interest income.

(i)According to the Fisher effect, what would be the nominal interest rates relevant to Jack and King respectively? (1 mark)

(ii)Compute the after-tax real interest rates for Jack and King respectively. (2 marks)

(iii)What is the cost of inflation implied by the above scenario? Briefly elaborate its adverse economic impact. (2 marks)

(iv)Suppose that King's brother takes out a loan from bank that charges at an interest rate of 14%. However, the actual inflation rate turns out to be 11% instead of 8% that was initially anticipated. Which party, bank or King's brother, will be better off? Discuss the cost of inflation implied by this scenario. (4 marks)