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Spring Term 2017
Yaşar University
Introduction to Economics II (Econ 102)
Problem Sheet 7
The Money Growth and Inflation
1.
Using separate graphs, demonstrate what happens to the money supply, money demand, the value of
money, and the price level if:
a. the Fed increases the money supply.
b. people decide to demand less money at each value of money.
ANSWER:
a. The Fed increases the money supply. When the Fed increases the money supply, we find the
consequences of their action by shifting the money supply curve to the right from MS1 to MS2.
This shift causes the value of money to fall, so the price level rises. See Exhibit 3.
b. People decide to demand less money at each value of money. Since people want to hold less at
each value of money, it follows that the money demand curve will shift to the left from MD1 to
MD2. The decrease in money demand results in a lower value of money and so a higher price
level. See Exhibit 4.
2.
According to the classical dichotomy, what changes nominal variables? What changes real variables?
ANSWER: The classical dichotomy argues that nominal variables are determined primarily by
developments in the monetary system such as changes in money demand and supply. Real variables
are largely independent of the monetary system and are determined by productivity and real changes
in the factor and loanable funds markets.
TYPE: S DIFFICULTY: 2 SECTION: 17.1
3.
Suppose that monetary neutrality holds. Of the following variables, which ones do not change when
the money supply increases?
a. real interest rates
b. inflation
c. the price level
d. real output
e. real wages
f. nominal wages
ANSWER:
a. real interest rates
d. real output
d. real wages
4.
Identify each of the following as nominal or real variables.
a. the physical output of goods and services
b. the overall price level
c. the dollar price of apples
d. the unemployment rate
e. the amount that shows up on your paycheck after taxes
f. the amount of goods you can purchase with the wage you get each hour
ANSWER:
a.
b.
c.
d.
e.
h.
real variable
nominal variable
nominal variable
real variable
nominal variable
real variable
5.
Define each of the symbols and explain the meaning of M  V = P  Y.
ANSWER: M is the quantity of money, V is the velocity of money, P is the price level, and Y is the quantity
of output. P  Y is nominal spending. The amount people spend should equal the amount of money in
the economy times the average number of times each unit of currency is spent.
TYPE: S DIFFICULTY: 1 SECTION: 17.1
6.
What assumptions are necessary to argue that the quantity equation implies that increases in the
money supply lead to proportional changes in the price level?
ANSWER: We must suppose that V is relatively constant and that changes in the money supply have no
effect on real output.
TYPE: S DIFFICULTY 1 SECTION 30.1
7.
What is the inflation tax, and how might it explain the creation of inflation by a central bank?
ANSWER: The inflation tax refers to the fact that inflation is a tax on money. When prices rise, the value of
your money is reduced. Hence, when a government raises revenue by printing money, it obtains
resources from households by taxing their money holdings through inflation rather than by sending
them a tax bill. In countries where governments are unable or unwilling to raise revenues by raising
taxes explicitly, the inflation tax may be an attractive alternative source of revenue.
TYPE: S DIFFICULTY: 1 SECTION: 17.2
8.
Suppose that velocity and output are constant and that the quantity theory and the Fisher effect both
hold. What happens to inflation, real interest rates, and nominal interest rates when the money supply
growth rate increases from 5 percent to 10 percent?
ANSWER: Inflation and nominal interest rates each increase by 5 percent points. There is no change in the
real interest rate or any other real variable.
9.
In recent years Bolivia, Russia, and Turkey have had much higher nominal interest rates than the
United States while Japan has had lower nominal interest rates. What would you predict is true about
money growth in these other countries? Why?
ANSWER: The Fisher effect says that increases in the inflation rate lead to one-to-one increases in nominal
interest rates. The quantity theory says that in the long run, inflation increases one-to-one with money
supply growth. It follows that differences in nominal interest rates may be due to differences in
inflation rates. There may be some difference in real interest rates, but if we suppose these are small,
then we predict that Bolivia, Russia, and Turkey have higher inflation, and Japan has lower inflation
than the United States.
10.
List and define any two of the costs of high inflation.
ANSWER: The costs include:
Shoeleather costs: the resources wasted when inflation induces people to reduce their money holdings
Menu costs: the cost of more frequent price changes at higher inflation rates
Relative Price Variability: higher inflation causes relative prices to vary more since prices change
infrequently. Decisions based on relative prices are then distorted
Inflation Induced Tax Distortions: the income tax is not completely indexed for inflation; an increase in
nominal income created by inflation results in higher real tax rates that discourage savings
Confusion and Inconvenience: inflation decreases the reliability of the unit of account making it more
complicated to differentiate successful and unsuccessful firms thereby impeding the efficient
allocation of funds to alternative investments
Unexpected Inflation: inflation decreases the real value of debt thereby transferring wealth from
creditors to debtors
1)
If inflation is less than expected, who benefits? Debtors or creditors? Explain.
If inflation is less than expected, creditors benefit and debtors lose. Creditors receive dollar payments from
debtors that have a higher real value than was expected.
Suppose that this year’s money supply is $500 billion, nominal GDP (PxY) is $10 trillion, and real GDP
2)
(Y) is 5 trillion.
a.
b.
What is the price level? What is the velocity of money?
Suppose that velocity is constant and the economy’s output of goods and services rises by 5% each
year. What will happen to nominal GDP and price level next year if the Central Bank keeps the
money supply constant?
c. What money supply should the Central Bank set next year if it wants to keep price level stable?
d. What money supply should the Central Bank set next year if it wants inflation of 10 % ?
In this problem, all amounts are shown in billions.
a.
b.
c.
d.
Nominal GDP = P x Y = $10,000 and Y = real GDP = $5,000, so P = (P x Y)/Y = $10,000/$5,000
= 2.
Since M x V = P x Y, then V = (P x Y)/M = $10,000/$500 = 20.
If M and V are unchanged and Y rises by 5 percent, then since M x V = P x Y, P must fall by 5
percent. As a result, nominal GDP is unchanged.
To keep the price level stable, the Fed must increase the money supply by 5 percent, matching the
increase in real GDP. Then, since velocity is unchanged, the price level will be stable.
If the Fed wants inflation to be 10 percent, it will need to increase the money supply 15 percent.
Thus M x V will rise 15 percent, causing P x Y to rise 15 percent, with a 10 percent increase in
prices and a 5 percent rise in real GDP.