CHAPTER 8

INFLATION

Difficulty: Easy
1. If inflation were always perfectly anticipated, then
A) its real costs would exactly equal the inflation rate
B) people would hold less cash but would still suffer losses since money balances are always
positive
C) the yield on interest-bearing assets would exactly compensate for losses on non-interest
bearing assets
D) unemployment would always be at 4 percent
E) wage indexation would not work
Ans: B

Difficulty: Medium
2. The concern over inflation
A) is not justified since gains and losses from real wealth transfers cancel out over time for the
economy as a whole
B) is irrational since high inflation generally means high growth
C) is attributable primarily to increased transfers arising from cost-of-living adjustments
D) stems from the fact that inflation is rarely predictable and those households who hold fixed
dollar assets will experience a loss in wealth
E) none of the above
Ans: D

Difficulty: Easy
3. Which of the following statements is FALSE?
A) homeowners with fixed-rate mortgages benefit from unanticipated high inflation
B) the costs of unanticipated inflation can be ignored, since the gains and losses of induced
wealth transfers tend to cancel each other out over the economy as a whole
C) Social Security beneficiaries are better protected against unanticipated inflation than workers
with long-term contracts
D) at least until 1985, the U.S. government gained from unanticipated inflation at the expense of
U.S. taxpayers
E) workers who received the minimum wage greatly suffered from unanticipated inflation
Ans: B

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Difficulty: Medium
4. The menu cost of inflation arises since
A) people hold less currency if inflation is positive and thus they take more trips to the bank
B) the central bank eventually has to restrict money supply and this causes an increase in the
unemployment rate
C) lenders are less likely to give out loans and this has a negative impact on economic activity
D) resources have to be devoted to marking up prices and changing vending machines and cash
registers
E) real wages and real money holdings lose purchasing power
Ans: D

Difficulty: Easy
5. If inflation this year is higher than expected, then
A) borrowers will gain at the expense of lenders
B) lenders will gain at the expense of borrowers
C) both lenders and borrowers will gain and the government will lose
D) both lenders and borrowers will lose
E) the government will lose unless it has implemented an indexed tax system
Ans: A

Difficulty: Easy
6. The unanticipated inflation of the last several decades benefited largely
A) elderly people whose major source of income comes from private pension plans
B) lending institutions, especially savings and loans
C) homeowners with fixed mortgage rates
D) taxpayers
E) all of the above
Ans: C

Difficulty: Easy
7. If inflation were always perfectly anticipated and contracts were written in real terms, then
A) there would only be a transfer of wealth from debtors to creditors
B) there would only be a transfer of wealth from creditors to debtors
C) there would only be a transfer of wealth from the poor to the rich
D) there would only be a transfer of wealth from households to firms
E) currency holders would have a negative rate of return
Ans: E

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Difficulty: Medium
8. If wages and prices were fully indexed,
A) there would be less inflation following an adverse supply shock
B) inflation could always be perfectly anticipated
C) inflation arising from money expansion could be prevented
D) the economy would have difficulty adjusting to supply shocks since real wages could not
adjust easily
E) politicians would be more likely to fight inflation vigorously
Ans: D

Difficulty: Easy
9. If this year's inflation rate was lower than expected, then
A) a transfer of wealth from the poor to the rich would occur
B) the government would gain tax revenues unless it had an indexed tax system
C) lenders would gain at the expense of borrowers
D) borrowers would gain at the expense of lenders
E) nominal wage rates would increase
Ans: C

Difficulty: Medium
10. A zero inflation target
A) eliminates the short-run unemployment-inflation tradeoff
B) is almost impossible to achieve since it would require an extremely high natural rate of
unemployment
C) can only be achieved if wage indexation is implemented nationwide
D) will have much lower costs than an explicit target of achieving a 4% long-term inflation rate
E) may not be as good as a positive inflation target, because it makes it more difficult to achieve
full employment
Ans: E

Difficulty: Easy
11. If the yearly inflation rate could be always be perfectly anticipated, then
A) currency holders would still have a negative rate of return
B) menu costs would still arise
C) people would still have to worry about shoe-leather costs
D) the costs of inflation to society would be small
E) all of the above
Ans: E

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Difficulty: Easy
12. Which of the following is TRUE, if inflation could be always perfectly anticipated?
A) no costs to society arise from inflation
B) there are no shoe-leather costs
C) there are no menu costs
D) currency holders would not experience any loss of purchasing power
E) none of the above
Ans: E

Difficulty: Medium
13. If you had $3,000 in a savings account that paid 5% interest compounded annually, how
much would you have in your account after five years?
A) $3,484
B) $3,629
C) $3,750
D) $3,829
E) $4,224
Ans: D

Difficulty: Medium
14. If you had $1,000 in a savings account that paid 4% interest compounded annually, how
much would you have in your account after three years?
A) $1,012
B) $1,120
C) $1,125
D) $1,250
E) $1,400
Ans: C

Difficulty: Medium
15. If you had $2,000 in a savings account that paid 4% interest compounded annually, what
would be the real value of your savings after two years if the annual inflation rate were 2%?
A) $2,040
B) $2,081
C) $2,160
D) $1,163
E) $2,247
Ans: B

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Difficulty: Medium
16. If you had $4,000 in a savings bank that pays you 2% interest per year, what would be the
real value of your savings after 2 years and the yearly inflation rate were 3% per year?
A) $3,959
B) $4,080
C) $4, 162
D) $4,244
E) $4,410
Ans: A

Difficulty: Easy
17. If a one-year bond pays a fixed interest rate of 2.5% per year and this year's inflation rate is
2.8%, what is your real rate of return?
A) 5.3%
B) 2.8%
C) 2.5%
D) 0.3%
E) -0.3%
Ans: E

Difficulty: Easy
18. What interest rate should a banker charge for a loan if she expects that the inflation rate will
average about 2.4% over the length of the loan, but wants she a 3% real rate of return?
A) 7.2%
B) 5.4%
C) 3.0%
D) 2.4%
E) 0.6%
Ans: B

Difficulty: Easy
19. Which of the following is TRUE?
A) the costs of unemployment on output are more apparent than the cost of inflation on output
B) the costs of inflation on output are more apparent than the cost of unemployment on output
C) the costs of inflation on output can be measured by Okun's law
D) unanticipated inflation only imposes a cost on currency holders
E) there are no costs to society from anticipated inflation
Ans: A

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Difficulty: Easy
20. When inflation rises unexpectedly, it is generally the case that
A) nominal interest rates and real interest rates will both rise at the same rate
B) nominal interest rates will rise while real interest rates will decline
C) real interest rates will rise while nominal interest rates will decline
D) all nominal wages will immediately be adjusted upwards
E) real wages will have to be adjusted upwards
Ans: B

Difficulty: Easy
21. If inflation were always completely unanticipated, then
A) the real rate of return on interest-bearing assets could not be easily predicted
B) real interest rates would always be negative
C) menu costs would not occur
D) there would not be a need for wage indexation
E) all of the above
Ans: A

Difficulty: Easy
22. Economists tend to agree that
A) the best inflation target is a zero percent inflation rate
B) the best inflation target is a two percent inflation rate
C) policy makers should never set inflation targets
D) any inflation target is fine, as long as policy makers announce it in advance
E) it is silly to think that all economists will ever agree on anything
Ans: E

Difficulty: Easy
23. Labor contracts that include so-called COLA provisions
A) tend to link money wages to price increases
B) serve to preserve the purchasing power of workers
C) are a common form of wage indexation in many labor markets
D) often tie nominal wages to a specific price index
E) all of the above
Ans: E

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Difficulty: Easy
24. Wage indexation
A) increases nominal wages periodically in accordance with the increase in prices over a given
time period
B) helps the economy adjust more rapidly back to the natural unemployment rate after a supply
shock
C) is a method of preventing inflation by taxing away what workers may have gained from
unanticipated inflation
D) provides protection against purchasing power loss for over half of the U.S. work force
E) is most prevalent n countries with a history of low inflation rates
Ans: A

Difficulty: Medium
25. The full indexation of wages and prices
A) is widespread in most industrial countries
B) would ensure that each year's inflation rate could always be correctly anticipated
C) would cause some real wage rigidities
D) would greatly help an economy to adjust back to full employment after a supply shock
E) would eliminate all lags between measuring price changes and making wage payments
Ans: C

Difficulty: Easy
26. The view that a small positive rate of inflation may actually be good for the economy was
first advanced by
A) Ben Bernanke
B) Milton Friedman
C) John Maynard Keynes
D) William Poole
E) James Tobin
Ans: E

Difficulty: Medium
27. An unanticipated increase in inflation is a problem since
A) gains and losses from real wealth transfers cannot be easily predicted
B) higher inflation always means lower growth in real GDP
C) it will lead to a decrease in nominal wages
D) households who hold fixed dollar assets will experience a higher real rate of return
E) none of the above
Ans: A

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Difficulty: Easy
28. An unanticipated increase in inflation will lead to a redistribution of wealth but
A) people who hold liquid assets will not suffer any losses
B) will not benefit borrowers in any way
C) will not lead to a change in the real wage rate
D) will not lead to a change in real interest rates
E) none of the above
Ans: E

Difficulty: Easy
29. The redistribution effect that arises from an unanticipated increase in inflation will affect
A) insurance contracts
B) cash holdings
C) people who own fixed rate bonds
D) all of the above
E) only B) and C)
Ans: D

Difficulty: Easy
30. The real return on a bond that pays a fixed interest is equal to
A) the nominal interest rate plus the rate of inflation
B) the nominal interest rate divided by the rate of inflation
C) the nominal interest rate minus the rate of inflation
D) the nominal interest rate times the rate of inflation
E) the interest rate that is stated on the bond
Ans: C

Difficulty: Easy
31. When considering the effects of widespread wage indexing
A) one has to distinguish between demand shocks and supply shocks
B) one always comes to the conclusion that they are ill-suited to protect against the loss of
purchasing power
C) one quickly realizes the benefits arising from less real wage rate rigidity
D) one realizes that it is very hard to tie nominal wages to a specific price index
E) none of the above
Ans: A

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Difficulty: Easy
31. The real return on a ten-year Treasury bond was highest in the period from
A) 1960-69
B) 1970-79
C) 1980-89
D) 1990-99
E) 2000-09
Ans: C

Difficulty: Easy
32. The losses from holding currency were highest in the period from
A) 1960-69
B) 1970-79
C) 1980-89
D) 1990-99
E) 2000-09
Ans: B

Difficulty: Medium
33. At age 18, you decided to bury $1,000 in your back yard and vowed not to use this money
until your planned retirement at age 65. What will be the approximate real purchasing power
of this money at that time, assuming that the average annual inflation rate over this time
period is 4%?
A) $1,000
B) $960
C) $660
D) $460
E) $160
Ans: E

Difficulty: Easy
34. An individual can, to some degree, reduce her vulnerability to high and unanticipated
inflation by
A) insisting on long-term wage contracts
B) holding long-term bonds
C) holding cash
D) wage indexation
E) all of the above
Ans: D

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Difficulty: Easy
35. In countries where inflation is high and volatile, partial protection from the cost of inflation
can be provided by
A) the indexation of debt
B) wage indexation
C) cost-of-living adjustments
D) all of the above
E) none of the above
Ans: D

Difficulty: Easy
36. People should be concerned about imperfectly anticipated inflation since
A) it results in a redistribution of wealth
B) debtors tend to profit while creditors tend to lose
C) equity holders experience a loss in the real value of fixed dividends
D) they may move into higher tax brackets as nominal wages are adjusted for inflation
E) all of the above
Ans: E

Difficulty: Easy
37. If you had owned a ten-year Treasury bond from 2000 to 2009, what would have been your
real rate of return?
A) 0.1%
B) 0.9%
C) 1.9%
D) 2.6%
E) 6.2%
Ans: C

Difficulty: Easy
38. If you lost $1,000 in cash in 2000 and found it again in 2009, the real purchasing power of
this cash would have changed by
A) -6.2%
B) -3.8%
C) -3.2%
D) -2.6%
E) -1.8%
Ans: D

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Difficulty: Easy
39. If your parents promised to give you $1,000 in cash every Christmas for the next 30 years,
what would be the real purchasing power of the final $1,000 if the average annual inflation
rate over this time period is 3 percent?
A) $820
B) $640
C) $520
D) $410
E) $320
Ans: D

Difficulty: Easy
40. In which time period was the average real yield on a ten-year Treasury bond the lowest?
A) 1960 to 1969
B) 1970 to 1979
C) 1980 to 1989
D) 1990 to 1999
E) 2000 to 2009
Ans: B

Difficulty: Easy
42. What was the average real rate of return of three-month Treasury bills during the period of
1970 to 1979?
A) 6.9%
B) 3.8%
C) 2.6%
D) 1.2%
E) -0.9%
Ans: E

Difficulty: Easy
41. A small amount of inflation may be good for the economy since
A) it will increase nominal GDP
B) there are no menu costs associated with small price adjustments
C) real wage adjustments can be achieved without nominal pay cuts
D) real interest rates will actually increase
E) none of the above
Ans: C

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Difficulty: Difficult
40. Assume you financed a new house with a 30-year fixed rate mortgage at a 6% annual
interest. rate. If you can deduct your mortgage interest payments from your taxable income
and you are in the 30% tax bracket, what would be the real after-tax cost of borrowing if the
average annual inflation rate is 4.2% over the 30-years period?
A) +4.2%
B) +1.8%
C) +1.2%
D) 0%
E) -1.2%
Ans: D

Difficulty: Easy
43. In which time period was the average real yield on a three-month Treasury bill the highest?
A) 1960 to 1969
B) 1970 to 1979
C) 1980 to 1989
D) 1990 to 1999
E) 2000 to 2009
Ans: C

Difficulty: Easy
45. If people always perfectly anticipated and adjusted to the inflation rate, then
A) real interest rates would be zero
B) there would be no menu costs
C) they would still have to worry about shoe-leather costs
D) the costs of inflation to society would be zero
E) none of the above
Ans: C

Difficulty: Easy
46. Which of the following is FALSE, if an increase in the inflation rate cannot be perfectly
anticipated?
A) there will be a redistribution of income and wealth
B) debtors will benefit while creditors will lose
C) the holder of an indexed government bond will lose
D) the government will gain real tax revenue
E) the real value of government debt will decline
Ans: C

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Difficulty: Medium
47. Which of the following is FALSE?
A) wage indexation is widespread in the U.S.
B) the economy will adjust to supply shocks more easily if there is widespread wage indexation
C) the holder of an indexed government bond will lose if an increase in inflation is unanticipated

D) the government loses real tax revenue if there is an unanticipated increase in the inflation rate
E) all of the above
Ans: E

Difficulty: Medium
48. Why are governments so reluctant to adopt widespread wage indexation?
A) it will make it more difficult to adjust to an adverse supply shock
B) widespread wage indexation is very complicated in practice
C) it may result in less political will to fight high inflation
D) all of the above
E) only A) and C)
Ans: D

Difficulty: Medium
49. Generally, the holder of a government bond that is indexed to the price level knows
A) either the interest rate, the principal, or both are adjusted for inflation
B) the real interest rate will fluctuate with inflation
C) there will be no losses as long as inflation is anticipated, but losses can occur if there is an
unanticipated increase in the inflation rate
D) all of the above
E) none of the above
Ans: A

Difficulty: Medium
50. Which of the following is FALSE?
A) automatic cost-of-living adjustments in formal labor contracts are common in many countries
B) wage indexation is more prevalent in countries where uncertainty about inflation is high
C) wage indexation is very widespread in the U.S.
D) an unanticipated increase in the inflation rate will increase the government’s real tax revenue
E) a government bond that is indexed to the price level will have either the interest, the
principal, or both adjusted for inflation
Ans: C
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