Download Suppose that this year`s money supply is $500 Bil

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Spring 2016
Chapter 17 Quiz
1. (20 pts) 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 the Velocity of money is constant and the economy’s output of goods and
services increases by 5% per 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 an inflation of 10%?
Answers
a.
Nominal GDP = P × Y = $10,000 and Y = real GDP = $5,000, so P = (P × Y )/Y =
$10,000/$5,000 = 2.
Because M × V = P × Y, then V = (P × Y )/M = $10,000/$500 = 20.
b.
If M and V are unchanged and Y rises by 5%, then because M × V = P × Y, P must fall
by 5%. As a result, nominal GDP is unchanged.
c.
To keep the price level stable, the Fed must increase the money supply by 5%, matching
the increase in real GDP. Then, because velocity is unchanged, the price level will be stable.
d.
If the Fed wants inflation to be 10%, it will need to increase the money supply 15%.
Thus M × V will rise 15%, causing P × Y to rise 15%, with a 10% increase in prices and a 5%
rise in real GDP.
2. (10 pts) Katarina puts money into an account. One year later she sees that she has 6 percent more
dollars and that her money will buy 4 percent more goods.
a. The nominal interest rate was 10 percent and the inflation rate was 6 percent.
b. The nominal interest rate was 6 percent and the inflation rate was 2 percent.
c. The nominal interest rate was 4 percent and the inflation rate was 2 percent.
d. The nominal interest rate was 10 percent and the inflation rate was 4 percent.
Answer b
3. (10 pts) James took out a fixed-interest-rate loan when the CPI was 200. He expected the CPI to
increase to 206 but it actually increased to 204. The real interest rate he paid is
a. higher than he had expected, and the real value of the loan is higher than he had expected.
b. higher than he had expected, and the real value of the loan is lower than he had expected.
c. lower than he had expected, and the real value of the loan is higher than he had expected.
d. lower then he had expected, and the real value of the loan is lower than he had expected.
Answer a
4. (10 pts) 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.
5. (10 pts) What is money demand? Why is it a downward sloping function of the inverse of the
price level?
Money demand is the amount of dollars that you want to hold in your pocket or non-interest
bearing checking count for any given value of money, i.e. the inverse of the price level. As P
increases, so 1/P fall, you want to hold more dollars because you need to have more dollars to buy
the same amount of goods. This is why money demand is downward sloping.
6. (10 pts) Suppose that an economy’s inflation rate increases sharply. What happens to the inflation
tax on the holders of money? Why is wealth that is held in savings accounts not subject to a
change in the inflation tax? Can you think of any way holders of savings accounts could be hurt
by the increase in the inflation rate?
If a country's inflation rate increases sharply, the inflation tax on holders of money increases
significantly. Wealth in savings accounts is not subject to a change in the inflation tax
because the nominal interest rate will increase with the rise in inflation. But holders of
savings accounts are hurt by the increase in the inflation rate because they are taxed on
their nominal interest income, so their real returns are lower.
7. (15 pts) Over Spring break you go to Florida to visit your dear grandparents. They ask you about
your classes, and of course you tell them how much you love Econ 103. Your grandfather, who
considers himself a well read person, goes on a tirade about how all the recent attention of the
Fed to inflation is misguided because as long as inflation is predicted, there are no real costs to
inflation. Is your dear old grandad, right or wrong? Explain.
Your grandfather is wrong in this case. Even if inflation is expected, there are real costs including
shoeleather costs associated with reduced money holdings, menu costs associated with more
frequent adjustment of prices, increased variability of relative prices, unintended changes in tax
liabilities due to nonindexation of the tax code, confusion and inconvenience resulting from a
changing unit of account.
8. (15 pts) Consider the money demand and money market diagram. Starting with an initial
equilibrium, show graphically how each of the following changes effects the price level
a. The Federal Reserve lowers the reserve requirement.
b. Consumers believe that their dollars will not be able to buy as many goods as before
c. A new app allows you to use your smart phone to pay for all the goods and services you
want to buy.