Download Short Questions

5A Ch.5
M.C. Questions
1.
7.
C
B
2.
8.
C
C
3.
9.
A
B
4.
D
5.
A
6.
A
Short Questions
1. Inflation is a persistent increase in the general price level. (2)
2.
Equation of exchange: MV = PY
M = Money supply; V = Velocity of circulation of money; P = Price level; Y = Real
income (2)
Assume that the velocity of circulation of money remains unchanged. (1) %P =
%M – %Y = 8% – 3% = 5% (2)
3.
Fisher equation: Real interest rate = Nominal interest rate – Anticipated inflation rate
(1) If the nominal interest rate is lower than the anticipated inflation rate, the real
interest rate is negative. (2)
4(a) It will gain. The unanticipated inflation leads to a fall in the purchasing power of
money, reducing the real wages it pays to the workers. (3)
4(b) They will lose. The unanticipated inflation leads to a fall in the purchasing power of
money, reducing the real value of the principal and interest to be received. (3)
5
The two motives for holding money are the transaction demand for money and the
asset demand for money. (2) The transaction demand for money is the demand for
money as a medium of exchange. The higher the real income, the more money is
needed for transactions. Hence, the money demand is positively related to real income.
(2) The asset demand for money is the demand for money as a store of value. The
higher the nominal interest rate, the higher is the cost of holding money. Hence, the
money demand is negatively related to the nominal interest rate. (2)
Structured Questions
1(a) Inflation is the result of ‘too much money chasing too few goods’. (1) High growth
rates in the money supply will result in high inflation. (1) Without a persistent increase
in the money supply, inflation cannot persist. (2)
1(b) Equation of exchange: MV = PY
M = Money supply; V = Velocity of circulation of money; P = Price level; Y = Real
income (2)
Assume that the velocity of circulation of money remains unchanged. (1) %M =
%P + %Y = 4% + 2% = 6% (2) The government should maintain the growth rate
of money supply at 6% per year.
2(a) The cost of holding cash is the nominal interest rate, i.e., 9%. (2)
2(b) Fisher equation: Nominal interest rate = Real interest rate + Anticipated inflation rate
Anticipated inflation rate = 9% – 3% = 6% (1) Since the purchasing power of cash will
fall by 6%, the real rate of return on cash is –6%. (2)
2(c) The real rate of return on bonds is the real interest rate, i.e., 3%. (2)
3(a) As the purchasing power of money rises, the real value of the principal and interest
lenders receive will increase, and the real value of the principal and interest borrowers
pay will increase. Hence, lenders will gain and borrowers will lose. (3)
3(b) Real interest rate = Nominal interest rate – Anticipated inflation rate
Realized real interest rate = Nominal interest rate – Actual inflation rate
If the inflation is fully anticipated, the realized real interest rate will be equal to the
anticipated real interest rate. There will be no redistributive effect. (3)
4(a)
Net monetary assets
($)
A
B
C
–20
0
15
4(b) A’s net monetary assets are negative. The fall in the purchasing power of money will
reduce his real liabilities. Hence, A will gain from the unanticipated inflation. (2) B’s
net monetary assets are 0. He does not gain or lose under the unanticipated inflation.
(2) C’s net monetary assets are positive. The fall in the purchasing power of money
will reduce the real value of his net monetary assets. Hence, C will lose under the
unanticipated inflation. (2)
5(a) The increase in the money supply will cause the interest rate to fall. (1) Diagram:
vertical money supply curve (1), money supply curve shifts to the right (1), interest
rate falls (1)
(b) A rise in the real GDP will increase the transaction demand for money. (1) If the extent
of the money supply curve’s shift to the right is larger than the extent of the money
demand curve’s shift to the right, the interest rate will fall. (2) Diagram: demand curve
shifts to the right (1), supply curve shifts to the right (1), interest rate falls (1)
News Commentary Questions
(a) Deflation is a persistent decrease in the general price level. (2)
(b)
(i) They will lose because they have to pay a higher real interest rate than anticipated. (2)
(ii) They will gain because the purchasing power of their ‘frozen’ salaries has risen. (2)
(c) During deflation, the price of assets (e.g., property) will fall, the wealth of people will
decrease. / A fall in prices will reduce the firms’ profits and investment incentives. The
economy will worsen. / During deflation, people’s wages may fall. (Any two, 2 + 2)