Tutorial 8

Money Growth and Inflation

I. Terms

1. quantity theory of money

2. nominal variables
3. real variables
4. classical dichotomy
5. monetary neutrality
6. velocity of money
7. quantity equation
8. inflation tax
9. Fisher effect
10. shoe leather costs
11. menu costs

II. Short-Answer Questions

1. Explain how an increase in the price level affects the real value of money.
2. According to the quantity theory of money, what is the effect of an increase in
the quantity of money?
3. Explain the difference between nominal and real variables and give two
examples of each. According to the principle of monetary neutrality, which
variables are affected by changes in the quantity of money?
4. According to the Fisher effect, how does an increase in the inflation rate affect
the real interest rate and the nominal interest rate?
5. What are the costs of inflation when inflation is perfectly anticipated?
6. If inflation is less than expected, who benefits— debtors or creditors? Union
workers or firms? Why?

III. Practice problems

1. Suppose that this year’s money supply is $500 billion, nominal GDP is $10
trillion, and real GDP is $5 trillion.
a. What is the price level? What is the velocity of money?
b. Suppose that velocity is constant and the economy’s output of goods
and services rises by 5 percent each year. What will happen to nominal
GDP and the price level next year if the Fed keeps the money supply
constant?
c. What money supply should the Fed set next year if it wants to keep the
price level stable?
d. What money supply should the Fed set next year if it wants inflation of
10 percent?

2. Suppose that changes in bank regulations expand the availability of credit

cards so that people need to hold less cash.
a. How does this event affect the demand for money?
b. If the Fed does not respond to this event, what will happen to the price
level?
 c. If the Fed wants to keep the price level stable, what should it do?
3. Hyperinflations are extremely rare in countries whose central banks are
independent of the rest of the government. Why might this be so?
4. Let’s consider the effects of inflation in an economy composed of only two
people: Bob, a bean farmer, and Rita, a rice farmer. Bob and Rita both always
consume equal amounts of rice and beans. In 2010, the price of beans was $1,
and the price of rice was $3.
a. Suppose that in 2011 the price of beans was $2 and the price of rice
was $6. What was inflation? Was Bob better off, worse off, or
unaffected by the changes in prices? What about Rita?
b. Now suppose that in 2011 the price of beans was $2 and the price of
rice was $4. What was inflation? Was Bob better off, worse off, or
unaffected by the changes in prices? What about Rita?
c. Finally, suppose that in 2011 the price of beans was $2 and the price of
rice was $1.50. What was inflation? Was Bob better off, worse off, or
unaffected by the changes in prices? What about Rita?
d. What matters more to Bob and Rita—the overall inflation rate or the
relative price of rice and beans?
5. If the tax rate is 40 percent, compute the before tax real interest rate and the
after-tax real interest rate in each of the following cases.
a. The nominal interest rate is 10 percent, and the inflation rate is 5
percent.
b. The nominal interest rate is 6 percent, and the inflation rate is 2 percent.
c. The nominal interest rate is 4 percent, and the inflation rate is 1 percent.
6. Suppose that people expect inflation to equal 3 percent, but in fact, prices rise
by 5 percent. Describe how this unexpectedly high inflation rate would help or
hurt the following:
a. the government
b. a homeowner with a fixed-rate mortgage
c. a union worker in the second year of a labor contract
d. a college that has invested some of its endowment in government
bonds
7. The following questions are related to the Fisher Effect
a. To demonstrate your understanding of the Fisher effect, complete the
table:
Real Interest Nominal Interest rate Inflation rate
3% 10% ………….
……. 6% 2%
5 ……….. 3%
The following questions about the Fisher effect are unrelated to the table
above:
b. Suppose people expect inflation to be 3%, and suppose the desired real
interest rate 4%. What is the nominal rate?
c. Suppose inflation turns out to be 6%. What is the actual real interest
rate on loans that were signed based on the expectations in part b?
d. Was wealth redistributed to the lender from the borrower or to the
borrower from the lender when inflation was expected to be 3%, but in
fact turned out to be 6%?
IV. Multiple- Choice Questions
1. In the long run, inflation is caused by
a. Banks that have market power and refuse to lend money.
b. Governments that raise taxes so high that it increases the cost of doing
business and, hence, raises prices.
c. Governments that print too much money.
d. Increases in the price of inputs, such as labor and oil.
e. None of the above.

2. What prices rise at an extraordinarily high rate, it is called

a. inflation
b. Hyperinflation.
c. Deflation.
d. Disinflation.

3. If the price level doubles,

a. The quantity demanded of money falls by half.
b. The money supply has been cut by half.
c. Nominal income is unaffected.
d. The value of money has been cut by half.
e. None of the above is true.

4. In the long run, the demand for money is most dependent upon
a. The level of prices.
b. The availability of credit cards.
c. The availability of banking outlets.
d. The interest rate.

5. The quantity theory of money concludes that an increase in the money supply
causes
a. A proportional increase in velocity.
b. A proportional increase in price.
c. A proportional increase in real output.
d. A proportional decrease in velocity.
e. A proportional decrease in prices.

6. An example of a real variable is

a. The nominal interest rate.
b. The ratio of the value of wages to the price of soda.
c. The price of corn.
d. The dollar wage.
e. None of the above.

7. The quantity equation states that

a. Money x price level = velocity x real output.
b. Money x real output = velocity x price level.
c. Money x velocity = price level x real output.
d. None of the above is true.

8. If money is neutral,
a. An increase in the money supply does nothing.
 b. The money supply cannot be changed because it is tied to a commodity such
as gold.
c. A change in the money supply only affects real variables such as real output.
d. A change in the money supply only affects nominal variables such as prices
and dollar wages.
e. A change in the money supply reduces velocity proportionately; therefore,
there is no effect on either prices or real output.

9. If the money supply grows 5 percent, and real output grows 2 percent, prices
should rise by
a. 5 percent.
b. Less than 5 percent.
c. More than 5 percent.
d. None of the above.

10. Velocity is
a. The annual rate of turnover of the money supply.
b. The annual rate of turnover of output.
c. The annual rate of turnover of business inventories.
d. Highly unstable.
e. Impossible to measure.

11. Countries that employ an inflation tax do so because

a. The government doesn’t understand the causes and consequences of inflation.
b. The government has a balanced budget.
c. Government expenditures are high and the government has inadequate tax
collections and difficulty borrowing.
d. An inflation tax is the most equitable of all taxes.
e. An inflation tax is the most progressive (paid by the rich) of all taxes.

12. An inflation tax is

a. An explicit tax paid quarterly by businesses based on the amount of increase
in the prices of their products.
b. A tax on people who hold money.
c. A tax on people who hold interest-bearing savings accounts.
d. Usually employed by governments with balanced budgets.
e. None of the above.

13. Suppose the nominal interest rate is 7 percent while the money supply is growing
at a rate of 5 percent per year. Assuming real output remains fixed, if the
government increases the growth rate of the money supply from 5 percent to 9
percent, the Fisher effect suggests that, in the long run, the nominal interest rate
should become
a. 4 percent.
b. 9 percent.
c. 11 percent.
d. 12 percent.
e. 16 percent.
14. If the nominal interest rate is 6 percent and the inflation rate is 3 percent, the real
interest rate is
a. 3 percent.
b. 6 percent.
c. 9 percent.
d. 18 percent.
e. None of the above.

15. If actual inflation turns out to be greater than people had expected, then
a. Wealth was redistributed to lenders from borrowers.
b. Wealth was redistributed to borrowers from lenders.
c. No redistribution occurred.
d. The real interest rate is unaffected.

16. Which of the following costs of inflation does not occur when inflation is constant
and predictable?
a. shoe leather costs
b. menu costs
c. costs due to inflation-induced tax distortions
d. arbitrary redistributions of wealth
e. costs due to confusion and inconvenience

17. Suppose that, because of inflation, a business in Russia must calculate, print, and
mail a new price list to its customers each month. This is an example of
a. Shoe leather costs.
b. Menu costs.
c. Costs due to inflation-induced tax distortions.
d. Arbitrary redistributions of wealth.
e. The Friedman rule.

18. Suppose that, because of inflation, people in Brazil economize on currency and go
to the bank each day to withdraw their daily currency needs. This is an example of
a. Shoe leather costs.
b. Menu costs.
c. Costs due to inflation-induced tax distortions.
d. Costs due to inflation-induced relative price variability, which misallocates
resources.
e. Costs due to confusion and inconvenience.

19. If the real interest rate is 4 percent, the inflation rate is 6 percent, and the tax rate
is 20 percent, what is the after-tax real interest rate?
a. 1 percent
b. 2 percent
c. 3 percent
d. 4 percent
e. 5 percent

20. Which of the following statements about inflation is not true?

a. Unanticipated inflation redistributes wealth.
b. An increase in inflation increases nominal interest rate.
c. If there is inflation, taxing nominal interest income reduces the return to
saving and reduces the rate of economic growth.
d. Inflation reduces people’s real purchasing power because it raises the cost of
the things people buy.