Download ANSWERS TO CHECKPOINT EXERCISES

ANSWERS TO CHECKPOINT EXERCISES
 CHECKPOINT 13.1 Money and the Interest Rate
1a. The nominal interest rate is 6 percent a year because that is the interest rate
at which the quantity of money demanded equals the quantity of money
supplied.
1b. If real GDP decreases, the interest rate falls. When real GDP decreases, the
demand for money curve shifts leftward. At the original interest rate,
people would like to hold less money than they are actually holding. So
they try to get rid of money by buying other financial assets such as bonds.
The demand for financial assets increases, the prices of these assets rise, and
the interest rate falls. The interest rate keeps falling until the quantity of
money that people want to hold increases to equal the quantity of money
supplied.
1c. If the Fed increases the quantity of money to $4.0 trillion, the interest rate
falls to 4 percent a year. At the original interest rate, people would like to
hold less money then they are actually holding. So they try to get rid of
money by buying other financial assets such as bonds. The demand for
financial assets increases, the prices of these assets rise, and the interest rate
falls. The interest rate keeps falling until the quantity of money that people
want to hold increases to equal the quantity of money supplied.
2a. The demand for money decreases as people use their credit cards more and
use money less for transactions.
2b. As the demand for money decreases, the nominal interest rate falls.
 CHECKPOINT 13.2 Money, the Price Level, and Inflation
1a. The nominal interest rate equals the real interest rate plus the inflation rate.
So the nominal interest rate equals the real interest rate, 5 percent a year,
plus the inflation rate, 6 percent a year, which is 11 percent a year.
1b. The nominal interest rate falls by 3 percentage points, from 11 percent a
year to 8 percent a year.
2.
The equation of exchange is M  V = P  Y. Rearranging this equation to
solve for M gives M = (P  Y)  V. Now, P  Y equals nominal GDP, which
is given in the problem as £900 billion. Velocity was given as 2. So the
quantity of money, M, is (£900 billion)  2, which is £450 billion.
3.
In growth rates, the equation of exchange is (Money growth) + (Velocity
growth) = (Inflation) + (Real GDP growth). Rearranging this equation gives
Inflation = (Money growth) + (Velocity growth)  (Real GDP growth). The
velocity of circulation is constant (at 2) so its growth equals 0 percent. Real
GDP grows at 5 percent a year and money grows at 8 percent a year, so
inflation equals (8 percent a year) + (0 percent a year)  (5 percent a year),
which is 3 percent a year.
 CHECKPOINT 13.3 The Cost of Inflation
a.
b.
The real interest rate is the nominal interest rate minus the inflation rate,
which is 18 percent a year minus 3 percent a year = 15 percent.
The real interest rate rises to 16 percent a year (18 percent a year minus 2
percent a year).
ANSWERS TO CHAPTER CHECKPOINT EXERCISES
1a. A demand for money curve is illustrated as
MD0 in Figure 13.1.
1b. An increase in real GDP increases the
demand for money and the demand for
money curve shifts rightward. Figure 13.1
illustrates this change as the shift from MD0
to MD1.
1c. A change in the interest rate changes the
quantity of money demanded. There is a
movement along the demand for money
curve. This change is illustrated in Figure
13.1 by the movement along the demand for
money curve MD0 from point A to point B
when the nominal interest rate falls from 6
percent a year to 4 percent a year.
1d. An increase in the number of families with
credit cards decreases the demand for
money. The demand for money curve shifts
leftward, from MD0 to MD2 in Figure 13.1
1e. The spread of ATMs has increased the demand for money. As a result, the
demand for money curve shifts rightward, from MD0 to MD1 in Figure
13.1
2a. The quantity of money demanded decreases in the short run because the
nominal interest rate rises. In the long run, the price level falls and so the
demand for money decreases.
2b. Initially the nominal interest rate rises, but in the long run it returns to its
initial value.
2c. Initially the increase in the nominal interest rate means that the real
interest rate rises. But, in the long run as the nominal interest rate returns
to its initial value so, too, does the real interest rate.
2d. Real GDP decreases in the short run but returns to potential GDP in the
long run.
2e. The price level falls a bit in the short run and falls even more in the long
run. In the long run, the price level falls by the same percentage decrease in
the quantity of money.
3a. If the Fed conducts an open market purchase of securities, the quantity of
money increases in both the short run and long run.
3b. In the short run, the increase in the quantity of money lowers the nominal
interest rate, so the quantity of money demanded increases. In the long
run, the nominal interest rate returns to its initial level, but the price level
rises, which increases the demand for money.
3c. In the short run, the increase in the quantity of money lowers the nominal
interest rate. In the long run, the price level rises, which increases the
demand for money so that the nominal interest rate returns to its initial
level
3d. The inflation rate does not immediately change, so in the short run the fall
in the nominal interest rate means that the real interest rate also falls. In the
long run, the nominal interest rate returns to its initial level. The inflation
rate does not change from a one-time increase in the quantity of money, so
the real interest rate returns to its initial level.
3e. In the short run, real GDP increases. In the long run, real GDP returns to
potential GDP.
3f. In the short run, the price level does not change. In the long run, the price
level rises by the same percentage as the increase in the quantity of money.
4a. The real interest rate equals the nominal interest rate minus the inflation
rate, so it is equal to 9.5 percent a year minus 3.1 percent a year, which is
6.4 percent a year.
4b. Velocity was not constant. Its growth rate equals inflation (3.1 percent a
year) plus real GDP growth (5.0 percent a year) minus money growth (8.3
percent a year), which is 0.2 percent a year; that is, its growth rate was
negative. The growth rate was negative because the quantity of money was
growing at a faster rate than the growth rate of GDP.
5.
The fall in the nominal interest rate lowers the real after-tax interest rate on
credit cards. The after-tax real interest rate equals the after-tax nominal
interest rate minus the inflation rate. Before the government’s new law, the
after-tax nominal interest rate was 10.5 percent. With the new law, it is 4.9
percent. So with no change in the inflation rate, the government has
decreased the after-tax real interest rate by 5.6 percentage points.
6.
Figure 13.2 shows the money market in the short run. Figure 13.3 shows
the money market in the long run.
6a. In the short run, the increase in the quantity of money lowers the nominal
interest rate. In Figure 13.2, the increase in the quantity of money from
$0.98 trillion to $1.00 trillion lowers the nominal interest rate from 5
percent to 3 percent. Because the inflation rate does not change in the short
run, the real interest rate also falls.
6b. In the long run, the price level rises, which increases the demand for
money and restores the nominal and real interest rates to their initial
values. The increase in the price level increases the demand for money and
in Figure 13.3, the demand for money curve shifts rightward from MD0 to
MD1. The nominal interest rate rises (back) to 5 percent and the real
interest rate rises (back) to its initial value.
6c. The short-run effects differ from the long-run effects because in the short
run the price level does not change. As time passes after an increase in the
quantity of money, the price level begins to rise. Eventually the price level
rises by the same percentage as the increase in the quantity of money. The
increase in the price level increases the demand for money so that the
nominal and real interest rates rise back to their original level.
7.
The quantity theory of money is the proposition that when real GDP
equals potential GDP, an increase in the quantity of money brings an equal
percentage increase in the price level.
8.
The velocity of circulation is the number of times in a year that the average
dollar of money gets used to buy final goods and services. The formula
used to measure the velocity of circulation is V = (P  Y)  M, where P is
the price level, Y is real GDP, and M is the quantity of money.
9a. The velocity of circulation, V is equal to (P  Y)  M, where P is the price
level, Y is real GDP and M is the quantity of money. Using this formula
gives V = (0.9  $10 trillion)  $3 trillion, which equals 3.
9b. M  V is equal to $3 trillion  3, or $9 trillion.
9c. Nominal GDP is P  Y, where P is the price level and Y is real GDP. So,
nominal GDP equals 0.9  $10 trillion, which is $9 trillion. Nominal GDP
also equals M  V.
10a. The inflation rate is the difference between the nominal interest rate and
the real interest rate. So the inflation rate is 7 percent a year  2 percent a
year, which is 5 percent a year.
10b. Money growth + Velocity growth = Inflation + Real GDP growth. Because
velocity is constant, its growth rate is zero. So, money growth equals 5
percent a year + 3 percent a year, which is 8 percent a year.
10c. The growth rate of nominal GDP is the sum of the inflation rate plus the
growth rate of real GDP. So the growth rate of nominal GDP is 5 percent a
year + 3 percent a year, which is 8 percent a year.
11a. The inflation rate is the difference between the nominal interest rate and
the real interest rate. So the inflation rate is 7 percent a year  2 percent a
year, which is 5 percent a year.
11b. Money growth + Velocity growth = Inflation + Real GDP growth.
Rearranging, Money growth = Inflation + Real GDP growth  Velocity,
which is 5 percent a year + 3 percent a year  1 percent a year = 7 percent a
year.
11c. The growth rate of nominal GDP is the sum of the inflation rate plus the
growth rate of real GDP. So the growth rate of nominal GDP is 5 percent a
year + 3 percent a year, which is 8 percent a year.
12. There are four costs of inflation:




Tax Costs. Inflation is a tax because inflation transfers resources from
households and businesses to government. This tax has a cost similar
to any other tax: People consume fewer goods and services because
some of their income is taxed. Inflation also interacts with the tax code
because there is an income tax levied on nominal interest. So, the
higher the inflation rate, the lower is the after-tax interest rate received
by lenders. With a low after-tax real interest rate, the incentive to save
is weakened, so the supply of saving and hence investment decreases.
This cost is reflected in lower economic growth and a resulting lower
standard of living.
Shoe-Leather Costs. Shoe-leather costs refer to the costs that arise from
an increase in the velocity of circulation of money and the increase in
the amount of running around that people do to try to avoid incurring
losses from the falling value of money. For instance, in hyperinflations,
people are paid twice a day and so must rush out twice a day to spend
their money on goods and services.
Confusion Costs. Inflation creates difficulty in measuring costs and
benefits when the price level is unstable. This cost can lead firms to
make incorrect decisions about what goods and services are in demand
and lead to inefficient production of goods and services.
Uncertainty Costs. The increased uncertainty of inflation makes longterm planning difficult and gives people a shorter-term focus.
Investment falls and so the economic growth rate falls.
13. When inflation hit 40 percent a month in Brazil, the costs of the inflation
for Brazilians were many. First, inflation is a tax. The government used the
inflation tax to buy goods and services, which crowded out private
spending. Second, there was no doubt a huge increase in the shoe-leather
costs of inflation, which arise from an increase in the velocity of circulation
of money because of the increase in the amount of running around that
people do to avoid incurring losses from the falling value of money. In
addition, the increased uncertainty made long-term planning difficult, if
not impossible and gave people a shorter-term focus. Investment fell and
so the growth rate slowed.
14. Businesses paid their workers twice a day to retain their work force.
Businesses knew that workers would see a large decline in the purchasing
power of money throughout the course of the day. If a firm delayed paying
its workers, the workers would suffer a tremendous loss in purchasing
power and so they might well quit to look for another, more
accommodating business. Workers spent their wages virtually as fast as
they received them to avoid the loss in value.
