Question 1

1. In the following examples, is inflation creating winners and losers at no net cost to the economy
or is inflation imposing a net cost on the economy? If a net cost is being imposed, which type of cost
is involved?
a. When inflation is expected to be high, workers get paid more frequently and make more trips to
the bank.
b. Lanwei is reimbursed by her company for her work-related travel expenses. Sometimes, however,
the company takes a long time to reimburse her. So when inflation is high, she is less willing to
travel for her job.
c. Hector Homeowner has a mortgage with a fixed nominal 6% interest rate that he took out five
years ago. Over the years, the inflation rate has crept up unexpectedly to its present level of 7%.
d. In response to unexpectedly high inflation, the manager of Cozy Cottages of Cape Cod must
reprint and resend expensive color brochures correcting the price of rentals this season.

a..This is an example of the effect of shoe-leather costs, a net cost of inflation to the economy.
Workers spend valuable resources going to the bank more frequently, firms spend valuable resources
(such as bookkeepers’ time) in paying workers more frequently, and banks spend more resources in
processing the greater volume of transactions.
b.This is an example of unit-of-account costs. A dollar when Lanwei spends it on a work -related
expense is worth more than a dollar she receives much later in reimbursement from her company.
Because she is less willing to travel for her job, there is a net cost to the economy of her forgone
output.
c.This is an example of inflation creating winners and losers. As the inflation rate creeps up
unexpectedly, the real value of the funds that Hector pays to the mort-gage company falls. So Hector
is better off as inflation increases, and the lender of his mortgage is worse off. At present, the real
interest rate on his mortgage is negative: 6% −7% =−1%. So he is now financing his house virtually
cost-free.
d.This is an example of menu costs, a net cost of inflation to the economy. The manager of Cozy
Cottages of Cape Cod must reprint and resend an expensive bro-chure because it is necessary to
raise the price of rentals due to unexpectedly high inflation.
Question 2

2. The accompanying diagram shows the interest rate on one-year loans and inflation during 2001–
2016 in the economy of Albernia. When would one-year loans have been especially attractive and
why?
One-year loans in Albernia would have been especially attractive from about 1998 to 2003. During
this time, inflation was higher than interest rates on one-year loans, making real interest rates
negative. Whenever nominal interest rates are lower than inflation, borrowers are better off and
lenders are worse off.
Question 3
3. The accompanying table provides the inflation rate in the year 2005 and the average inflation rate over
the period 2006–2015 for seven different countries.
a. Given the expected relationship between average inflation and menu costs, rank the countries in
descending order of menu costs using average inflation over the period 2006– 2015.
Turkey, Indonesia, Brazil, China, US, France, Japan
b. Rank the countries in order of inflation rates that most favored borrowers with ten-year loans that were
taken out in 2005. Assume that the loans were agreed upon with the expectation that the inflation rate for
2006 to 2015 would be the same as the inflation rate in 2005.
<<<Most favorable for borrowers>>>
China
Turkey
Japan
France
Brazil
United States
Indonesia
<<<Least favorable for borrowers>>>
c. Did borrowers who took out ten-year loans in Japan gain or lose overall versus lenders? Explain.
Borrowers gained and lenders lost.

Question 4

4. Eastland College is concerned about the rising price of textbooks that students must purchase. To better
identify the increase in the price of textbooks, the dean asks you, the Economics Department’s star student,
to create an index of textbook prices. The average student purchases three English, two math, and four
economics textbooks per year. The prices of these books are given in the accompanying table.

a. What is the percent change in the price of an English textbook from 2012 to 2014?

The percent change in the price of an English textbook from 2012 to 2014 is 14.0% (equal to (($57 -
$50)/$50) X 100).

b. What is the percent change in the price of a math textbook from 2012 to 2014?

The percent change in the price of a math textbook from 2012 to 2014 is 5.7% (equal to (($74 - $70)/$70) X
100).

c. What is the percent change in the price of an economics textbook from 2012 to 2014?

The percent change in the price of an economics textbook from 2012 to 2014 is 25% (equal to (($100 - $80)/
$80) X 100).
d. Using 2012 as a base year, create a price index for these books for all years.

To create an index of textbook prices, you must first calculate the cost of the market basket (three English,
two math, and four economics textbooks) in each of the three years; then normalize it by dividing the cost
of the market basket in a given year by the cost of the market basket in the base period; and then multiply
by 100 to get an index value (base period of 2012 = 100). Cost of textbooks in 2012 = (3 X $50) + (2 X $70) +
(4 X $80) = $610 Cost of textbooks in 2013 = (3 X $55) + (2 X $72) + (4 X $90) = $669 Cost of textbooks in
2014 = (3 X $57) + (2 X $74) + (4 X $100) = $719 Index value for 2012 = ($610/$610) X 100 = 100.0 Index
value for 2013 = ($669/$610) X 100 = 109.7 Index value for 2014 = ($719/$610) X 100 = 117.9

e. What is the percent change in the price index from 2012 to 2014?

The percent change in the price index for textbooks from 2012 to 2014 is 17.9% (equal to ((117.9 –
100)/100) X 100).

10 question
The main advantage to printing money to cover the deficit is to avoid the crowding-out effects—the
reduction in private investment spending that occurs due to higherinterest rates arising from
government borrowing. However, the main disadvantage toprinting money to cover the deficit is
that it will result in inflation and individualswho currently hold money pay an inflation tax (a
reduction in the value of moneyheld by the public). Rather than financing the budget deficit with an
increase in actu-al taxes, printing money imposes an inflation tax.

12 question
Over the first year, as prices fall 10%, the value of the Millers’ house will fall from$105,000 to
$94,500. Since they borrowed $100,000 to buy it, the value of the houseis now less than the amount
they owe. If they sold the house, they would not be ableto pay off their mortgage. The Millers are
worse off. The mortgage company is betteroff because as the Millers pay off their mortgage, the
mortgage company will be ableto lend to more potential homeowners. As the deflation continues, it
will becomeharder and harder for the Millers to pay off their mortgage. Assuming wages arefalling
with deflation, the Millers will have to work more hours to pay off the mort-gage. The Millers will
cut back on their consumer spending. At some point, the Millerswill decide to walk away from the
house and default on the mortgage. Both theMillers and the mortgage company will lose, as will the
economy. The Millers will findit difficult to borrow at all because they defaulted on the mortgage,
and the mortgagecompany will be reluctant to lend for fear that the borrower will default.
Continuingdeflation would be extremely detrimental to the economy. Individuals and firms willbe
reluctant to borrow, fearing that the value of their assets will fall even though thevalue of their debt
remains fixed, and lenders will be reluctant to lend, fearing thatthe borrowers will default and they
will own assets whose value is less than the amount they lent.
13 question
Countries such as Japan will find that they can sustain an unemployment rate lowerthan the NAIRU
for longer periods of time before the expected rate of inflationincreases than countries such as
Zimbabwe. So Japanese monetary and fiscal policywill be more effective than Zimbabwean
monetary and fiscal policy in reducingunemployment below the NAIRU. However, given a
sufficiently long period of higher-than-expected inflation, the Japanese people will revise their
expected rate of inflationupward, and the Japanese short-run Phillips curve will shift upward. So
the long-runJapanese Phillips curve is still vertical. In contrast, Zimbabwe will find that its short-run
Phillips curve is practically vertical: because people are primed to quickly revisetheir inflationary
expectations, an unemployment rate below the NAIRU will quicklycause an acceleration of
inflation. So Zimbabwean monetary and fiscal policy arelargely ineffective even in the short run in
reducing unemployment below the NAIRU.