QUESTIONS FOR REVIEW

1. Explain how an increase in the price level affects the real value of money.
An increase in the price level will result in a decrease of the real value of money and a
decrease the purchasing power of the consumers.
2. According to the quantity theory of money, what is the effect of an increase in the
quantity of money?
According to the quantity theory of money, an increase in the quantity of money causes
a proportional increase in the price level.
3. Explain the difference between nominal variables and real variables and give two
examples of each. According to the principle of monetary neutrality, which variables
are affected by changes in the quantity of money?
Nominal variables are those measured in monetary units, while real variables are those
measured in physical units. Examples of nominal variables include the prices of goods,
wages, and nominal GDP. Examples of real variables include relative prices (the price
of one good in terms of another), real wages, and real GDP. According to the principle
of monetary neutrality, only nominal variables are affected by changes in the quantity
of money.
4. In what sense is inflation like a tax? How does thinking about inflation as a tax help
explain hyperinflation?
Inflation is like a tax because everyone who holds money loses purchasing power.
In a hyperinflation, the government increases the money supply rapidly, which leads
to a high rate of inflation. Thus the government uses the inflation tax, instead of taxes,
to finance its spending.
5. According to the Fisher effect, how does an increase in the inflation rate affect the real
interest rate and the nominal interest rate?
According to the Fisher effect, an increase in the inflation rate raises the nominal
interest rate by the same amount that the inflation rate increases, with no effect on the
real interest rate.
6. What are the costs of inflation? Which of these costs do you think are most important
for the U.S. economy?
The costs of inflation include shoeleather costs associated with reduced money
holdings,
menu costs associated with more frequent adjustment of prices, increased variability of
relative prices, inflation induced tax distortions, confusion and inconvenience resulting
from a changing unit of account, and arbitrary redistributions of wealth between debtors
and creditors. With a low and stable rate of inflation like that in the United States, none
of these costs are very high. Perhaps the most important one is the interaction between
inflation and the tax code, which may reduce saving and investment even though the
inflation rate is low.
7. 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.
 PROBLEMS AND APPLICATIONS

1. 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 that velocity is constant and the economy’s output of goods and services rises
by 5 percent each 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 inflation of 10 percent?
a P=10 trillion/5 trillion=2, V= 10 trillion/500 billion=20
b.New Real GDP=5 trillion×1.05=5.25 trillion
=>New Nominal GDP=Money Supply×Velocity=500 billion×20=10 trillion
=> P’= 10/5,25=1.90
c. Desired Nominal GDP=P×Y=2×5.25 trillion=10.5 trillion
Setting the velocity at 20, the required money supply is: M=nominal GDP/ V= 525B
d. New Nominal GDP=10 trillion×1.10=11 trillion=> M=550B

2. Suppose that changes in bank regulations expand the availability of credit cards so that
people can hold less cash. a. How does this event affect the demand for money? b. If
the Fed does not respond to this event, what will happen to the price level? c. If the Fed
wants to keep the price level stable, what should it do?
a. The availability of credit cards decreases the demand for money. b. Without a Fed
response, there may be a rise in the price level (inflation). c. The Fed should reduce
the money supply to keep the price level stable
3. It is sometimes suggested that the Fed should try to achieve zero inflation. If we assume
that velocity is constant, does this zero-inflation goal require that the rate of money
growth equal zero? If yes, explain why. If no, explain what the rate of money growth
should equal.
No, the rate of money growth should not equal zero if there is an increase in total
transactions (T). To maintain zero inflation, the rate of money growth should equal the rate
of growth in total transactions.
4. Suppose that a country’s inflation rate increases sharply. What happens to the inflation
tax on the holders of money? Why is wealth held in savings accounts not subject to a
change in the inflation tax? Can you think of any way in which holders of savings
accounts are hurt by the increase in inflation?
The inflation tax on the holders of money increases as the inflation rate rises, reducing
the purchasing power of their money. Savings accounts are not directly subjected to the
inflation tax if their interest rates compensate for inflation. However, if inflation
exceeds the interest rate, the real value of savings decreases, indirectly affecting
account holders.
5. Let’s consider the effects of inflation in an economy composed of only two people:
Bob, a bean farmer, and Rita, a rice farmer. Bob and Rita both always consume equal
amounts of rice and beans. In 2019, the price of beans was $1 and the price of rice was
$3. a. Suppose that in 2020 the price of beans was $2 and the price of rice was $6. What
was inflation? Did the price changes leave Bob better off, worse off, or unaffected?
What about Rita? b. Now suppose that in 2020 the price of beans was $2 and the price
of rice was $4. What was inflation? Did the price changes leave Bob better off, worse
off, or unaffected? What about Rita? c. Finally, suppose that in 2020 the price of beans
was $2 and the price of rice was $1.50. What was inflation? Did the price changes leave
Bob better off, worse off, or unaffected? What about Rita? d. What matters more to
Bob and Rita—the overall inflation rate or the relative price of rice and beans?
a. Inflation was 100%; both Bob and Rita were unaffected. b. Inflation was 100% for
beans and 33.33% for rice; Bob was better off, Rita was worse off. c. Inflation was
100% for beans and -50% for rice; Bob was worse off, Rita was better off. d. The
relative price of rice and friends matters more to Bob and Rita than the overall inflation
rate.

6. Assuming a tax rate of 40 percent, compute the before-tax real interest rate and the
after-tax real interest rate for each of the following cases. a. The nominal interest rate
is 10 percent, and the inflation rate is 5 percent. b. The nominal interest rate is 6 percent,
and the inflation rate is 2 percent. c. The nominal interest rate is 4 percent, and the
inflation rate is 1 percent.
The before-tax real interest rates are 5%, 4%, and 3% for the three cases respectively.
The after-tax real interest rates are 1%, 1.6%, and 1.4% for the respective cases.

7. Recall that money serves three functions in the economy. What are those functions?
How does inflation affect the ability of money to serve each of these functions?
The functions of money are Medium of Exchange, Unit of Account, and Store of Value.
Inflation makes money less efficient as a medium of exchange, undermines its role as
a unit of account by making prices less stable, and diminishes its function as a store of
value by reducing its purchasing power over time.
8. Suppose that people expect inflation to be 3 percent but that, in fact, prices rise by 5
percent. Describe how this unexpectedly high inflation would help or hurt the
following: a. the government b. a homeowner with a fixed-rate mortgage c. a union
worker in the second year of a labor contract d. a college that has invested some of its
endowment in government bonds
Unexpectedly high inflation from 3% to 5% helps the government and homeowners
with fixed-rate mortgages by reducing the real value of their debt payments.
Conversely, it hurts union workers on set wage increases and colleges with
endowments in government bonds because the real value of their income and
investment returns decreases.
9. Explain whether the following statements are true, false, or uncertain. a. “Inflation hurts
borrowers and helps lenders, because borrowers must pay a higher rate of interest.” b.
“If prices change in a way that leaves the overall price level unchanged, then no one is
made better or worse off.” c. “Inflation does not reduce the purchasing power of most
workers.”
A.False. Inflation actually hurts lenders and helps borrowers. When inflation is high,
the value of money decreases, meaning that borrowers are paying back their loans with
money that is worth less than when they borrowed it. While borrowers may pay higher
nominal interest rates in an inflationary environment, the real interest rate (nominal rate
adjusted for inflation) can be lower, benefiting borrowers.
b.Uncertain.
While the overall price level may remain unchanged, relative price changes can affect
individuals differently. For example, if the price of one good rises while others fall,
some consumers may be worse off (if they rely on the more expensive good), while
others may benefit (if they purchase the cheaper goods). Thus, the overall impact on
individuals can vary even if the aggregate price level remains constant.
c.False.
Inflation generally reduces the purchasing power of money, including wages. If wages
do not increase at the same rate as inflation, workers effectively lose purchasing power
because their income buys fewer goods and services. While some workers may receive
cost-of-living adjustments, not all do, meaning inflation can adversely affect many
workers' purchasing power.