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Name TestBanks Chapter 5 Inflation: Its Causes, Effects, and Social Costs
Description
Instructions

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Multiple Choice 1 points

Question
The rate of inflation is the:
Answer median level of prices.
average level of prices.
percentage change in the level of prices.
measure of the overall level of prices.

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Multiple Choice 1 points

Question
The definition of the transactions velocity of money is:
Answer money multiplied by prices divided by transactions.
transactions divided by prices multiplied by money.
money divided by prices multiplied by transactions.
prices multiplied by transactions divided by money.

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Multiple Choice 1 points

Question
If there are 100 transactions in a year and the average value of each transaction is $10, then if there is $200 of money
in the economy, transactions velocity is ______ times per year.
Answer 0.2
2
5
10

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Multiple Choice 1 points

Question
If the transactions velocity of money remains constant while the quantity of money doubles, the:
Answer price of the average transaction must double.
number of transactions must remain constant.
price of the average transaction multiplied by the number of transactions must remain constant.
price of the average transaction multiplied by the number of transactions must double.

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Multiple Choice 1 points

Question
The quantity equation, viewed as an identity, is a definition of the:
Answer quantity of money.
quantity of transactions.
price level.
transactions velocity of money.

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Multiple Choice 1 points

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Question
The income velocity of money:
Answer is defined in the identity MV = PY.
is defined in the identity MV = PT.
is the same thing as the transactions velocity of money.
is the same as the number of times a dollar bill changes hands.

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Multiple Choice 1 points

Question
The transactions velocity of money indicates the _____ in a given period, while the income velocity of money indicates
the _____ in a given period.
Answer number of transactions; amount of income earned
quantity of money used for transactions; quantity of money paid as income
number of times a dollar bill changes hands; number of times a dollar bill enters someone's income
volume of transactions; flow of income

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Multiple Choice 1 points

Question
Real money balances equal the:
Answer sum of coin, currency, and balances in checking accounts.
amount of money expressed in terms of the quantity of goods and services it can purchase.
number of dollars used as a medium of exchange.
quantity of money created by the Federal Reserve.

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Multiple Choice 1 points

Question
If the average price of goods and services in the economy equals $10 and the quantity of money in the economy
equals $200,000, then real balances in the economy equal:
Answer 10.
20,000.
200,000.
2,000,000.

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Question
The demand for real money balances is generally assumed to:
Answer be exogenous.
be constant.
increase as real income increases.
decrease as real income increases.

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Multiple Choice 1 points

Question
If the quantity of real money balances is kY, where k is a constant, then velocity is:
Answer k.
1/k.
kP.
P/k.

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Multiple Choice 1 points

Question
If the demand for real money balances is proportional to real income, velocity will:

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Answer increase as income increases.

increase as income decreases.
vary directly with the interest rate.
remain constant.

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Multiple Choice 1 points

Question
When the demand for money parameter, k, is large, the velocity of money is ______ and money is changing hands
______
Answer large; frequently
large; infrequently
small; frequently
small; infrequently

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Multiple Choice 1 points

Question
d
Consider the money demand function that takes the form (M/P) = kY, where M is the quantity of money, P is the price
level, k is a constant, and Y is real output. If the money supply is growing at a 10 percent rate, real output is growing at
a 3 percent rate, and k is constant, what is the average inflation rate in this economy?
Answer 3 percent
7 percent
10 percent
13 percent

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Multiple Choice 1 points

Question
The income velocity of money increases and the money demand parameter k ______ when people want to hold
______ money.
Answer increases; more
increases; less
decreases; more
decreases; less

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Multiple Choice 1 points

Question
The quantity equation for money, by itself:
Answer may be thought of as a definition for velocity.
implies that the velocity of money is constant.
implies that the price level is proportional to the money supply.
implies that real gross domestic product (GDP) is proportional to the money supply.

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Multiple Choice 1 points

Question
The quantity theory of money assumes that:
Answer income is constant.
velocity is constant.
prices are constant.
the money supply is constant.

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Question
If income velocity is assumed to be constant, but no other assumptions are made, the level of ______ is determined by
M.

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Answer prices
income
transactions
nominal GDP

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Multiple Choice 1 points

Question
If velocity is constant and, in addition, the factors of production and the production function determine real GDP, then:
Answer the price level is proportional to the money supply.
real GDP is proportional to the money supply.
the price level is fixed.
nominal GDP is fixed.

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Multiple Choice 1 points

Question
In the long run, according to the quantity theory of money and the classical macroeconomic theory, if velocity is
constant, then ______ determines real GDP and ______ determines nominal GDP.
Answer the productive capability of the economy; the money supply
the money supply; the productive capability of the economy
velocity; the money supply
the money supply; velocity

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Multiple Choice 1 points

Question
According to the quantity theory of money, ultimate control over the rate of inflation in the United States is exercised by:
Answer the Organization of Petroleum Exporting Countries (OPEC).
the U.S. Treasury.
the Fed.
private citizens.

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Multiple Choice 1 points

Question
According to the quantity theory of money, if money is growing at a 10 percent rate and real output is growing at a 3
percent rate, but velocity is growing at increasingly faster rates over time as a result of financial innovation, the rate of
inflation must be:
Answer increasing.
decreasing.
7 percent.
constant.

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Multiple Choice 1 points

Question
If the money supply increases 12 percent, velocity decreases 4 percent, and the price level increases 5 percent, then
the change in real GDP must be ______ percent.
Answer 3
4
9
11

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Multiple Choice 1 points

Question
Percentage change in P is approximately equal to the percentage change in:

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Answer M.
M minus percentage change in Y.
M minus percentage change in Y plus percentage change in velocity.
M minus percentage change in Y minus percentage change in velocity.

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Multiple Choice 1 points

Question
Using average rates of money growth and inflation in the United States over many decades, Friedman and Schwartz
found that decades of high money growth tended to have ______ rates of inflation and decades of low money growth
tended to have ______ rates of inflation.
Answer high; high
high; low
low; low
low; high

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Multiple Choice 1 points

Question
Using decade-long data across countries from 20002010, countries with high money growth tend to have _____
inflation.
Answer high
low
constant
decreasing

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Question
The right of seigniorage is the right to:
Answer levy taxes on the public.
borrow money from the public.
draft citizens into the armed forces.
print money.

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Question
Inflation tax means that:
Answer as the price level rises, taxpayers are pushed into higher tax brackets.
as the price level rises, the real value of money held by the public decreases.
as taxes increase, the rate of inflation also increases.
in a hyperinflation, the chief source of tax revenue is often the printing of money.

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Question
The inflation tax is paid:
Answer only by the central bank.
by all holders of money.
only by government bond holders.
equally by every household.

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Question
The percentage of government revenue raised by printing money has usually accounted for:

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Answer more than 10 percent of government revenue in the United States.

less than 3 percent of government revenue in the United States.
less than 3 percent of government revenue in Italy.
less than 3 percent of government revenue in Greece.

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Multiple Choice 1 points

Question
During the American Revolution, the price of gold measured in continental dollars increased to more than ______
times its previous level.
Answer 2
10
50
100

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Multiple Choice 1 points

Question
The real interest rate is equal to the:
Answer amount of interest that a lender actually receives when making a loan.
nominal interest rate plus the inflation rate.
nominal interest rate minus the inflation rate.
nominal interest rate.

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Multiple Choice 1 points

Question
If the nominal interest rate is 1 percent and the inflation rate is 5 percent, the real interest rate is:
Answer 1 percent.
6 percent.
4 percent.
5 percent.

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Question
If the real interest rate declines by 1 percent and the inflation rate increases by 2 percent, the nominal interest rate
must:
Answer increase by 2 percent.
increase by 1 percent.
remain constant.
decrease by 1 percent.

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Multiple Choice 1 points

Question
If the real interest rate and real national income are constant, according to the quantity theory and the Fisher effect, a 1
percent increase in money growth will lead to rises in:
Answer inflation of 1 percent and the nominal interest rate of less than 1 percent.
inflation of 1 percent and the nominal interest rate of 1 percent.
inflation of 1 percent and the nominal interest rate of more than 1 percent.
both inflation and the nominal interest rate of less than 1 percent.

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Question
The one-to-one relation between the inflation rate and the nominal interest rate, the Fisher effect, assumes that the:

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Answer money supply is constant.

velocity is constant.
inflation rate is constant.
real interest rate is constant.

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Multiple Choice 1 points

Question
According to the quantity theory a 5 percent increase in money growth increases inflation by ___ percent. According to
the Fisher equation a 5 percent increase in the rate of inflation increases the nominal interest rate by _____.
Answer 1; 5
5; 1
1; 1
5; 5

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Multiple Choice 1 points

Question
According to the quantity theory and the Fisher equation, if the money growth increases by 3 percent and the real
interest rate equals 2 percent, then the nominal interest rate will increase:
Answer 2 percent.
3 percent.
5 percent.
6 percent.

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Question
In the classical model, according to the quantity theory and the Fisher equation, an increase in money growth
increases:
Answer output.
velocity
the nominal interest rate.
the real interest rate.

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Multiple Choice 1 points

Question
Evidence from the past 40 years in the United States supports the Fisher effect and shows that when the inflation rate
is high, the ______ interest rate tends to be ______.
Answer nominal; high
nominal; low
real; high
real; low

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Question
The ex ante real interest rate is equal to the nominal interest rate:
Answer minus the inflation rate.
plus the inflation rate.
minus the expected inflation rate.
plus the expected inflation rate.

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Question
When a person purchases a 90-day Treasury bill, he or she cannot know the:

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Answer ex post real interest rate.

ex ante real interest rate.
nominal interest rate.
expected rate of inflation.

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Question
Equilibrium in the market for goods and services determines the ______ interest rate and the expected rate of inflation
determines the ______ interest rate.
Answer ex ante real; ex ante nominal
ex post real; ex post nominal
ex ante nominal; ex post real
ex post nominal; ex post real

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Question
The ex ante real interest rate is based on _____ inflation, while the ex post real interest rate is based on _____
inflation.
Answer expected; actual
core; actual
actual; expected
expected; core

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Multiple Choice 1 points

Question
According to the Fisher effect, the nominal interest rate moves one-for-one with changes in the:
Answer inflation rate.
expected inflation rate.
ex ante real interest rate.
ex post real interest rate.

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Multiple Choice 1 points

Question
A positive relationship between nominal interest rates and inflation in the United States is obvious in:
Answer both recent data and nineteenth-century data.
recent data but not nineteenth-century data.
nineteenth-century data but not recent data.
neither nineteenth-century data nor recent data.

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Multiple Choice 1 points

Question
The ex post real interest rate will be greater than the ex ante real interest rate when the:
Answer rate of inflation is increasing.
rate of inflation is decreasing.
actual rate of inflation is greater than the expected rate of inflation.
actual rate of inflation is less than the expected rate of inflation.

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Multiple Choice 1 points

Question
In recent U.S. experience, inflation has:
Answer been persistent from year to year, whereas in the nineteenth century inflation had little persistence.
been persistent from year to year, and this was also true in the nineteenth century.
not been persistent from year to year, although it was persistent in the nineteenth century.

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not been persistent from year to year, and the same was true in the nineteenth century.

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Question
The opportunity cost of holding money is the:
Answer nominal interest rate.
real interest rate.
federal funds rate.
prevailing Treasury bill rate.

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Question
The real return on holding money is:
Answer the real interest rate.
minus the real interest rate.
the inflation rate.
minus the inflation rate.

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Question
If the real return on government bonds is 3 percent and the expected rate of inflation is 4 percent, then the cost of
holding money is ______ percent.
Answer 1
3
4
7

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Multiple Choice 1 points

Question
The general demand function for real balances depends on the level of income and the:
Answer real interest rate.
nominal interest rate.
rate of inflation.
price level.

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Multiple Choice 1 points

Question
If the nominal interest increases, then:
Answer the money supply increases.
the money supply decreases.
the demand for money increases.
the demand for money decreases.

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Multiple Choice 1 points

Question
d
Consider the money demand function that takes the form (M/P) = Y/4i, where M is the quantity of money, P is the price
level, Y is real output, and i is the nominal interest rate. What is the average velocity of money in this economy?
Answer i
4i
1/4i
0.25

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Multiple Choice 1 points

Question
If the Fed announces that it will raise the money supply in the future but does not change the money supply today,
Answer both the nominal interest rate and the current price level will decrease.
the nominal interest rate will increase and the current price level will decrease.
the nominal interest rate will decrease and the current price level will increase.
both the nominal interest rate and the current price level will increase.

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Multiple Choice 1 points

Question
If the money supply is held constant, then an increase in the nominal interest rate will ______ the demand for money
and ______ the price level.
Answer increase; increase
increase; decrease
decrease; increase
decrease; decrease

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Question
If the demand for money depends on the nominal interest rate, then via the quantity theory and the Fisher equation, the
price level depends on:
Answer only the current money supply.
only the expected future money supply.
both the current and expected future money supply.
neither the current nor the expected future money supply.

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Multiple Choice 1 points

Question
According to the classical theory of money, reducing inflation will not make workers richer because firms will increase
product prices ______ each year and give workers ______ raises.
Answer more; larger
more; smaller
less; larger
less; smaller

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Multiple Choice 1 points

Question
According to the classical theory of money, inflation does not make workers poorer because wages increase:
Answer faster than the overall price level.
more slowly than the overall price level.
in proportion to the increase in the overall price level.
in real terms during periods of inflation.

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Multiple Choice 1 points

Question
Survey evidence indicates that economists worry ______ the general public does about prices increasing more rapidly
than their incomes.
Answer more than
less than
about the same as
more intensely than

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Multiple Choice 1 points

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Question
All of the following are costs of fully expected inflation except that expected inflation:
Answer causes lower real wages.
leads to shoeleather costs.
increases menu costs.
leads to taxing of nominal capital gains that are not real.

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Question
The inconvenience associated with reducing money holdings to avoid the inflation tax is called:
Answer menu costs.
shoeleather costs.
variable yardstick costs.
fixed costs.

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Question
The costs of reprinting catalogs and price lists because of inflation are called:
Answer menu costs.
shoeleather costs.
variable yardstick costs.
fixed costs.

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Question
Inflation ______ the variability of relative prices and ______ allocative efficiency.
Answer increases; increases
increases; decreases
decreases; decreases
decreases; increases

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Multiple Choice 1 points

Question
Devoting resources to avoiding the costs of expected inflation leads to:
Answer eliminating the costs of expected inflation.
fewer relative price changes.
economic inefficiency.
a decrease in the transaction velocity of money.

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Multiple Choice 1 points

Question
Variable inflation hurts both debtors and creditors because:
Answer inflation makes the money-fixed assets of creditors worth less.
inflation makes the money-fixed liabilities of debtors worth less.
most debtors and creditors are risk averse.
most debtors and creditors are risk neutral.

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Question
In the case of an unanticipated inflation:
Answer creditors with an unindexed contract are hurt because they get less than they expected in real terms.
creditors with an indexed contract gain because they get more than they contracted for in nominal terms.

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debtors with an unindexed contract do not gain because they pay exactly what they contracted for in
nominal terms.
debtors with an indexed contract are hurt because they pay more than they contracted for in nominal
terms.

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Multiple Choice 1 points

Question
The costs of unexpected inflation, but not of expected inflation, are:
Answer menu costs.
the arbitrary redistribution of wealth between debtors and creditors.
unintended distortions of individual tax liabilities
the costs of relative price variability.

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Multiple Choice 1 points

Question
Between 1880 and 1896, the price level in the United States fell 23 percent. This movement was ______ for bankers of
the Northeast and ______ for farmers of the South and West.
Answer bad; bad
good; good
good; bad
bad; good

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Multiple Choice 1 points

Question
A variable rate of inflation is undesirable because:
Answer debtors and creditors cannot protect themselves by indexing contracts.
shoeleather costs are greater under variable inflation than under constant inflation.
menu costs are greater under variable inflation than under constant inflation.
variable inflation leads to greater uncertainty and risk than under constant inflation.

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Question
One possible benefit of moderate inflation is:
Answer a reduction in boredom attributable to the changing prices.
the elimination of menu costs.
better functioning labor markets.
increased certainty about the future.

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Multiple Choice 1 points

Question
If inflation is 6 percent and a worker receives a 4 percent wage increase, then the worker's real wage:
Answer increased 4 percent.
increased 2 percent.
decreased 2 percent.
decreased 6 percent.

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Question
If nominal wages cannot be cut, then the only way to cut real wages is by:
Answer inflation.
unions.
legislation.
productivity increases.

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Multiple Choice 1 points

Question
A rate of inflation that exceeds 50 percent per month is typically referred to as a(n):
Answer conflagration.
hyperinflation.
deflation.
disinflation.

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Question
Compared to periods of lower rates of inflation, during a hyperinflation all of the following occur except:
Answer shoeleather costs increase.
menu costs become larger.
relative prices do a better job of reflecting true scarcity.
tax distortions increase.

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Question
Hyperinflations ultimately are the result of excessive growth rates of the money supply; the underlying motive for the
excessive money growth rates is frequently a government's:
Answer desire to increase prices throughout the economy.
need to generate revenue to pay for spending.
responsibility to increase nominal interest rates by increasing expected inflation.
inability to conduct open-market operations.

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Question
Which of the following would most likely be called a hyperinflation?
Answer Price increases averaged 300 percent per year.
The inflation rate was 10 percent per year.
Real GDP grew at a rate of 12 percent over a year.
A stock market index rose by 1,000 points over a year.

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Question
In instances of hyperinflation, the delays involved in collecting taxes often result in:
Answer decreased real government tax revenue.
large capital gains for creditors.
higher shoeleather costs of inflation.
higher ex ante real interest rates.

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Question
During hyperinflation real tax revenue of the government often drops substantially because of the:
Answer delay between when a tax is levied and when it is collected.
significantly greater menu costs of printing tax forms.
additional deductions taken for increased shoeleather costs.
greater uncertainty associated with extreme rates of inflation.

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Question
The major source of government revenue in most countries that are experiencing hyperinflation is:
Answer customs duties.
income taxes.
seigniorage.
borrowing.

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Question
In practice, in order to stop a hyperinflation, in addition to stopping monetary growth, the government must:
Answer lower taxes and raise government spending.
raise taxes and reduce government spending.
change from one kind of currency to another.
call for a new election.

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Question
To end a hyperinflation, a government trying to reduce its reliance on seigniorage would:
Answer print more money.
raise taxes and cut spending.
lower taxes and increase spending.
lower interest rates.

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Multiple Choice 1 points

Question
Most hyperinflations end with _____ reforms that eliminate the need for _____.
Answer monetary; taxes
monetary; currency
fiscal; seigniorage
fiscal; currency

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Multiple Choice 1 points

Question
The hyperinflation experienced by interwar Germany illustrates how fiscal policy can be connected to monetary policy
when government expenditures are financed by:
Answer new taxes.
borrowing in the open market.
printing large quantities of money.
selling gold.

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Multiple Choice 1 points

Question
In Zimbabwe in the 1990s the government resorted to printing money to pay the salaries of government employees
because:
Answer it was a means to avoid price controls.
of high rates of inflation.
of declining tax revenues.
of a need to stimulate the economy.

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Question
Which of the following is an example of a relative price?

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Answer the real interest rate

the capital stock
the dollar wage per hour
the price level

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Question
An example of a real variable is the:
Answer dollar wage a person earns.
quantity of goods produced in a year.
price level.
nominal interest rate.

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Question
An example of a nominal variable is the:
Answer money supply.
quantity of goods produced in a year.
relative price of bread.
real wage.

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Question
Variables expressed in terms of physical units or quantities are called ______ variables.
Answer real
nominal
endogenous
exogenous

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Question
Variables expressed in terms of money are called ______ variables.
Answer real
nominal
endogenous
exogenous

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Question
The classical dichotomy:
Answer cannot hold if money is neutral.
is said to hold when the values of real variables can be determined without any reference to nominal
variables or the existence of money.
fully describes the world in which we live, especially in the short run.
arises because money depends on the nominal interest rate.

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Question
According to the classical dichotomy, when the money supply decreases, _____ will decrease.
Answer real GDP
consumption spending
the price level

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investment spending

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Question
The concept of monetary neutrality in the classical model means that an increase in the money supply will increase:
Answer real GDP.
real interest rates.
nominal interest rates.
both saving and investment by the same amount.

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Question
The characteristic of the classical model that the money supply does not affect real variables is called:
Answer the monetary basis.
monetary policy.
the quantity theory of money.
monetary neutrality

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Question
The theoretical separation of real and monetary variables is called:
Answer the classical dichotomy.
monetary neutrality.
the Fisher effect.
the quantity theory of money.

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Question
If the price level depends on both the current money supply and future expected money supplies, in order to stop a
hyperinflation, a central bank may try to establish credibility by:
Answer achieving increased political independence from the government.
increasing revenue from seigniorage.
encouraging increased government spending and tax cuts.
undertaking larger open-market purchases.

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Question
A small country might want to use the money of a large country rather than print its own money if the small country:
Answer is likely to be unstable, whereas the large country is likely to be stable.
is likely to be stable, whereas the large country is likely to be unstable.
needs the revenue for seigniorage.
wants to control its own inflation rate.

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Question
The phrase inflation is repudiation applies only if:
Answer inflation is expected.
the government has no debt.
the government is a creditor.
the government is a debtor.

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Multiple Choice 1 points

Question
If consumption depends positively on the level of real balances, and real balances depend negatively on the nominal
interest rate in a neoclassical model, then:
Answer the classical dichotomy still holds.
a rise in money growth leads to a fall in consumption and a rise in investment.
a rise in money growth leads to a rise in consumption and a fall in investment.
a rise in money growth leads to a rise in both consumption and investment.

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Multiple Choice 1 points

Question
If consumption depends positively on the level of real balances and real balances depend negatively on the nominal
interest rate in a neoclassical model, then the nominal interest rate:
Answer declines when the money growth rate rises.
is unchanged when the money growth rate rises.
rises 1 percent for each 1 percent rise in the money growth rate.
rises less than 1 percent for each 1 percent rise in the money growth rate.

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Essay 1 points

Question
Assume that a series of inflation rates is 1 percent, 2 percent, and 4 percent, while nominal interest rates in the same
three periods are 5 percent, 5 percent, and 6 percent, respectively.
a. What are the ex post real interest rates in the same three periods?
b. If the expected inflation rate in each period is the realized inflation rate in the previous period, what are
the ex ante real interest rates in periods two and three?
c. If someone lends in period two, based on the ex ante inflation expectation in part b, will he or she be
pleasantly or unpleasantly surprised in period 3 when the loan is repaid?

Answer a. 4 percent; 3 percent; 2 percent

b. 4 percent; 4 percent
c. He or she will be unpleasantly surprised.

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Question
Mary Tsai is paid $3,000 every 30 days. Her salary is deposited directly in her bank. She spends all her money at a
constant rate over the 30 days and must pay cash. She can (1) withdraw all of the money at once; (2) withdraw half at
once and the rest after 15 days; (3) withdraw one-third at once, one-third after 10 days, and one-third at 20 days; or (4)
make any number of evenly spaced withdrawals. Each withdrawal costs her $2 in terms of time and inconvenience. For
each day that Mary has a dollar in the bank, she gets .03 cents (.0003 per dollar) in interest. Thus, if she withdraws half
of her money immediately and half in 15 days, she has $1,500 in the bank for 15 days and earns $6.75 interest.
a. Create a table showing transaction costs, interest earned, and total net earnings (+) or cost ()
associated with one, two, three, or four withdrawals per month.
b. How many withdrawals per month lead to the largest net earnings? If Mary chooses this number, what
will be her average amount of cash on hand over the 30 days?

Answer a.
Number of Transaction Interest Net Earnings (+)
Withdrawals Costs Earned or Costs ()
1 $2 $ 0.00 $2.00
2 4 6.75 2.75
3 6 9.00 3.00
4 8 10.125 2.125
b. Mary should choose to make three withdrawals per pay period.

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Question
Assume that the demand for real money balance (M/P) is M/P = 0.6Y 100i, where Y is national income and i is the
nominal interest rate (in percent). The real interest rate r is fixed at 3 percent by the investment and saving functions.
The expected inflation rate equals the rate of nominal money growth.
a. If Y is 1,000, M is 100, and the growth rate of nominal money is 1 percent, what must i and P be?
b. If Y is 1,000, M is 100, and the growth rate of nominal money is 2 percent, what must i and P be?

Answer a. i = 4 percent, P = 1/2

b. i = 5 percent, P = 1

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Question
A classical economist wears a T-shirt printed with the slogan Fast Money Raises My Interest! Use the quantity theory
of money and the Fisher equation to explain the slogan.
Answer According to the quantity theory, if velocity and real output are constant, then increases in the rate of money
growth increase the rate of inflation. Fast money increases inflation. Based on the Fisher equation, the
nominal interest rate equals the real interest rate plus the rate of inflation. If the real interest rate is constant,
the higher inflation (from the faster money growth rate) raises the nominal interest rate.
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Question
In classical macroeconomic theory, the concept of monetary neutrality means that changes in the money supply do not
influence real variables. Explain why changes in money growth affect the nominal interest rate, but not the real interest
rate.
Answer According to the Fisher equation, the nominal interest rate equals the real interest rate plus the expected rate
of inflation. The expected rate of inflation depends on the rate of money growth, so the nominal interest rate
depends on the rate of money growth. According to classical macroeconomic theory, the real interest rate
adjusts to bring the level of saving and investment (both real variables) into equilibrium without reference to
the rate of money growth.
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Econoland finances government expenditures with an inflation tax.
a. Explain who pays the tax and how it is paid.
b. What are costs of the tax, assuming the tax rate is expected?

Answer a. Holders of money pay the inflation tax, since the purchasing power of their money holdings declines as
a result of inflation generated when the government prints more money.
b. The inflation tax rate is the rate of inflation. If the inflation (tax) rate is expected, then the costs of
expected inflation include shoeleather costs, menu costs, the costs of relative price variability, tax
distortions, and the inconvenience of making inflation corrections.

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Question
If the demand for money depends positively on real income and depends inversely on the nominal interest rate, what
will happen to the price level today, if the central bank announces (and people believe) that it will decrease the money
growth rate in the future, but it does not change the money supply today?
Answer People will expect lower inflation in the future. The nominal interest rate will fall. Money demand will increase.
Since the central bank does not immediately decrease the money supply, prices must fall to keep the newly
increased money demand equal to the constant money supply. Thus, current prices fall as a result of expected
future decreases in money growth rates.
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Question
Although inflation is always and everywhere a monetary phenomenon, explain why:
a. the start of a hyperinflation is typically related to the fiscal policy situation, and
b. the end of a hyperinflation is usually related to changes in fiscal policy.

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Answer a. Hyperinflations frequently begin when governments require additional revenue from seigniorage
because tax revenue and/or government borrowing is insufficient to cover government spending. The
additional seigniorage is obtained by printing money, which leads to hyperinflation.
b. Hyperinflations usually end when fiscal policy changes, including tax increases and government
spending cuts, are made to eliminate the need for seigniorage and stops the excessive increase in
money.

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Question
Consider two countries, Hitech and Lotech. In Hitech new arrangements for making payments, such as credit cards
and ATMs, have been enthusiastically adopted by the population, thereby reducing the proportion of income that is
held as real money balances. Over this period no such changes occurred in Lotech. If the rate of money growth and
the growth rate of real GDP were the same in Hitech and Lotech over this period, then how would the rate of inflation
differ between the two countries? Carefully explain your answer.
Answer The rate of inflation would be higher in Hitech. According to the quantity theory, if the rates of money growth
and real GDP growth rates are the same, differences in rates of inflation are related to differences in velocity.
An increase in velocity leads to a higher rate of inflation, holding other factors constant. In Hitech the reduction
in the proportion of income held as real balances (smaller k) is the equivalent of an increase in velocity and,
consequently, a higher rate of inflation in Hitech than in Lotech.
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Question
Interest rates played a part in the 1984 U.S. presidential debates. Some politicians claimed that interest rates rose over
the 19811983 period, while others claimed rates fell. Below is a table showing interest rates and annual inflation rates
from 1981 to 1983.
Interest Rate Annual
Year (annual %) Inflation Rate
1981 14.03% 10.3%
1982 10.69% 6.2%
1983 8.63% 3.2%
Reconcile these conflicting claims.
Answer Using the Fisher effect, the nominal interest rate fell from 14 percent to 8.6 percent over the period, but the
ex post real interest rate rose from 3.73 percent to 5.43 percent.
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Question
The costs of expected inflation cause productive resources of an economy to be directed away from their efficient
allocation. Explain how each of the following costs of expected inflation distort the allocation of productive resources:
a. shoeleather costs
b. menu costs
c. the inconvenience of a changing price level

Answer a. Resources are used to go to the bank and in other activities to reduce cash holding, rather than in
producing goods and services.
b. Resources are used to update prices on menus, in catalogs, and on other price lists, rather than in
producing goods and service.
c. Resources are used to specify and compare the value of dollars at different t

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