Chapter 17

Money Growth and Inflation

True/False
1. U.S. prices rose at an average annual rate of about 4 percent over the last 70 years.
ANS: T
2. The United States has never had deflation.
ANS: F
3. In the 1990s, U.S. prices rose at about the same rate as in the 1970s.
ANS: F
4. The quantity theory of money can explain hyperinflations but not moderate inflation.
ANS: F
5. If P represents the price of goods and services measured in money, then 1/P is the value of money measured in terms of goods and
services.
ANS: T
6. When the value of money is on the vertical axis, an increase in the price level shifts money demand to the right.
ANS: F
7. The money supply curve shifts to the left when the Fed buys government bonds.
ANS: F
8. When the value of money is on the vertical axis, the money supply curve slopes upward because an increase in the value of money
induces banks to create more money.
ANS: F
9. If the Fed increases the money supply, the equilibrium value of money decreases and the equilibrium price level must increase.
ANS: T

10. A rising price level eliminates an excess supply of money.

ANS: T

11. Nominal GDP measures output of final goods and services in physical terms.
ANS: F

12. The classical dichotomy is useful for analyzing the economy because in the long run nominal variables are heavily influenced by
developments in the monetary system, and real variables are not.
ANS: T

13. The irrelevance of monetary changes for real variables is called monetary neutrality. Most economists accept monetary neutrality
as a good description of the economy in the long run, but not the short run.
ANS: T

14. The quantity theory implies that if output and velocity are constant, then a 50 percent increase in the money supply would lead to
less than a 50 percent increase in the price level.
ANS: F

15. The source of all four classic hyperinflations was high rates of money growth.
ANS: T

16. In the long run, an increase in the growth rate of the money supply leads to an increase in the real interest rate, but no change in
the nominal interest rate.
ANS: F

17. Inflation induces people to spend more resources maintaining lower money holdings. The costs of doing this are called shoeleather
costs.
ANS: T

18. Inflation distorts savings when the nominal rather than the real interest rate is taxed.
ANS: T

19. If the Fed were to unexpectedly increase the money supply, creditors would gain at the expense of debtors.
ANS: F

20. Even though monetary policy is neutral in the short run, it may have profound real effects in the long run.
ANS: F
Short Answer
1. Why did farmers in the late 1800s dislike deflation?
ANS: Most had large nominal debts. The decrease in the price level meant that they received less for what they produced and so made
it harder to pay off the debts whose real value rose as prices fell.

2. Explain the adjustment process in the money market that creates a change in the price level when the money supply increases.
ANS: When the money supply increases, there is an excess supply of money at the original value of money. After the money supply
increases, people have more money than they want to hold in their purses, wallets and checking accounts. They use this excess money
to buy goods and services or lend it out to other people to buy goods and services. The increase in expenditures causes prices to rise
and the value of money to fall. As the value of money falls, the quantity of money people want to hold increases so that the excess
supply is eliminated. At the end of this process the money market is in equilibrium at a higher price level and a lower value of money.

3. Suppose the Fed sells government bonds. Use a graph of the money market to show what this does to the value of money.
ANS: When the Fed sells government bonds, the money supply decreases. This shifts the money supply curve from MS1 to MS2 and
makes the value of money increase. Since money is worth more, it takes less to buy goods with it, which means the price level falls.

4. Using separate graphs, demonstrate what happens to the money supply, money demand, the value of money, and the price level if:
a. the Fed increases the money supply.
b. people decide to demand less money at each value of money.
ANS: a. The Fed increases the money supply. When the Fed increases the money supply, the money supply curve shifts right from
MS1 to MS2. This shift causes the value of money to fall, so the price level rises.
b. People decide to demand less money at each value of money. Since people want to hold less at each value of money, it follows that
the money demand curve will shift to the left from MD1 to MD2. The decrease in money demand results in a lower value of money and
so a higher price level.

5. According to the classical dichotomy, what changes nominal variables? What changes real variables?
ANS: The classical dichotomy argues that nominal variables are determined primarily by developments in the monetary system such
as changes in money demand and supply. Real variables are largely independent of the monetary system and are determined by
productivity and real changes in the factor and loanable funds markets.

6. Suppose that monetary neutrality holds. Of the following variables, which ones do not change when the money supply increases?
a. real interest rates
b. inflation
c. the price level
d. real output
e. real wages
f. nominal wages
ANS: a. real interest rates
d. real output
e. real wages

7. Wages and prices are many times higher today than they were 30 years ago, yet people do not work a lot more hours or buy fewer
goods. How can this be?
ANS: Inflation has raised the general price level. An increase in the general price level has no effect on real variables in the long run.
Wages are higher, but so are prices. Prices are higher, but so are wages and incomes. In the long run, people change their behavior in
response to changes in real variables, not nominal ones.

8. Identify each of the following as nominal or real variables.

a. the physical output of goods and services
b. the overall price level
c. the dollar price of apples
d. the price of apples relative to the price of oranges
e. the unemployment rate
f. the amount that shows up on your paycheck after taxes
g. the amount of goods you can purchase with the wage you get each hour
h. the taxes that you pay the government
ANS: a. real variable
b. nominal variable
c. nominal variable
d. real variable
e. real variable
f. nominal variable
g. real variable
h. nominal variable

9. Define each of the symbols and explain the meaning of M × V = P × Y.

ANS: M is the quantity of money, V is the velocity of money, P is the price level, and Y is the quantity of output. P × Y is nominal
GDP. The amount people spend should equal the amount of money in the economy times the average number of times each unit of
currency is spent.

10. What assumptions are necessary to argue that the quantity equation implies that increases in the money supply lead to proportional
changes in the price level?
ANS: We must suppose that V is relatively constant and that changes in the money supply have no effect on real output.

11. What is the inflation tax, and how might it explain the creation of inflation by a central bank?
ANS: The inflation tax refers to the fact that inflation is a tax on money. When prices rise, the value of money currently held is
reduced. Hence, when a government raises revenue by printing money, it obtains resources from households by taxing their money
holdings through inflation rather than by sending them a tax bill. In countries where governments are unable or unwilling to raise
revenues by raising taxes explicitly, the inflation tax may be an alternative source of revenue.

12. Economists agree that increases in the money supply growth rate increase inflation and that inflation is undesirable. So why have
there been hyperinflations and how have they been ended?
ANS: Typically, the government in countries that had hyperinflation started with high spending, inadequate tax revenue, and limited
ability to borrow. Therefore, they turned to the printing presses to pay their bills. Massive and continued increases in the quantity of
money led to hyperinflation, which ended when the governments instituted fiscal reforms eliminating the need for the inflation tax and
subsequently slowed money supply growth.

13. Suppose that velocity and output are constant and that the quantity theory and the Fisher effect both hold. What happens to
inflation, real interest rates, and nominal interest rates when the money supply growth rate increases from 5 percent to 10 percent?
ANS: Inflation and nominal interest rates each increase by 5 percent points. There is no change in the real interest rate or any other
real variable.

14. In recent years Venezuela and Russia have had much higher nominal interest rates than the United States while Japan has had
lower nominal interest rates. What would you predict is true about money growth in these other countries? Why?
ANS: The Fisher effect says that increases in the inflation rate lead to one-to-one increases in nominal interest rates. The quantity
theory says that in the long run, inflation increases one-to-one with money supply growth. It follows that differences in nominal
interest rates may be due to differences in money supply growth rates. It is reasonable to guess that much higher nominal interest rates
in Venezuela and Russia indicate higher money supply growth while lower interest rates in Japan indicate lower money supply
growth.

15. The U.S. Treasury Department issues inflation-indexed bonds. What are inflation-indexed bonds and why are they important?
ANS: Inflation-indexed bonds are bonds whose interest and principal payments are adjusted upward for inflation, guaranteeing their
real purchasing power in the future. They are important because they provide a safe, inflation-proof asset for savers and they may
allow the Treasury to borrow more easily at a lower current cost.

16. List and define any two of the costs of high inflation.
ANS: The costs include:
Shoeleather costs: the resources wasted when inflation induces people to reduce their money holdings.
Menu costs: the cost of more frequent price changes at higher inflation rates.
Relative Price Variability: because prices change infrequently, higher inflation causes relative prices to vary more.
Decisions based on relative prices are then distorted so that resources may not be allocated efficiently.
Inflation Induced Tax Distortions: the income tax is not completely indexed for inflation; an increase in nominal income created by
inflation results in higher real tax rates that discourage savings.
Confusion and Inconvenience: inflation decreases the reliability of the unit of account making it more complicated to differentiate
successful and unsuccessful firms thereby impeding the efficient allocation of funds to alternative investments.
Unexpected Inflation: inflation decreases the real value of debt thereby transferring wealth from creditors to debtors.

17. Inflation distorts relative prices. What does this mean and why does it impose a cost on society?
ANS: Relative prices are the value of one good in terms of other goods. Relative prices ordinarily provide signals concerning the
relative scarcity of goods so the goods may be allocated efficiently. Some prices change infrequently, so that when inflation rises,
there is greater variation in relative prices. However, changes in relative prices created by inflation do not signal changes in the
scarcity of goods and so lead to an inefficient allocation of goods and resources.

18. Explain how inflation affects savings.

ANS: Inflation discourages savings. Income tax is collected on nominal rather than real interest rates. So an increase in inflation will
increase nominal interest rates and taxes. The increase in taxes in turn lowers the real return on savings and so discourages savings.

19. The U.S. Treasury Department began issuing inflation-indexed bonds in early 1997. Since these assets are virtually risk free, both
in terms of default risk and inflation risk, will they quickly replace all other kinds of assets that still entail risk of one kind or another,
such as ordinary government bonds or corporate bonds? Explain.
ANS: When individuals are choosing between assets of different kinds, they consider both expected return and risk. Because the new
inflation-indexed bonds have very low risk, they will also have very low real interest rates. So they will not replace other, more risky
assets that promise to pay a much higher real interest rate. They do, however, offer a way of escaping some inflation risk, and have
become a popular addition to portfolios.