Money Growth and Inflation

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How the Supply and Demand for Money Determine the Equilibrium Price Level

An Increase in the Money Supply

quantity theory of money

a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate

nominal variables

variables measured in monetary units

real variables

variables meaured in physical units

classical dichotomy

the theoretical separation of nominal and real variables

monetary neutrality

the proposition that changes in the money supply do not affect real variables

velocity of money

the rate at which money changes hands
V = (P x Y) / M

V = velocity
P = Price level
Y = real GDP
M = qty of money

quantity equation

M x V = P x Y
the qty of money, the velocity of money and the dollar value of the economy's output of goods and services

inflation tax

the revenue the government raises by creating money

Fisher effect

the one-for-one adjustment of the nominal interest rate to the inflation rate

Real interest rate

= Nominal interest rate - Inflation rate

Nominal interest rate

= Real interest rate + Inflation rate

The UK Nominal Interest Rate and the Inflation Rate

shoeleather costs

the resources wasted when inflation encourages people to reduce their money holdings

menu costs

the costs of changing prices

An increase in the price level is the same as a decrease in the value of money. T or F?

T

The quantity theory of money suggests that an increase in the money supply
increases real output proportionately. T or F?

F

If the price level were to double, the quantity of money demanded would double because people would need twice as much money to cover the same transactions. T or F?

T

In the long run, an increase in the money supply tends to have an effect on real variables but no effect on nominal variables. T or F?

F

If the money supply is €500, real output is 2,500 units, and the average price of a unit of real output is €2, the velocity of money is 10. T or F?

T

The Fisher effect suggests that, in the long run, if the rate of inflation rises from 3 per cent to 7 per cent, the nominal interest rate should increase by 4 percentage points and the real interest rate should remain unchanged. T or F?

T

An inflation tax is paid by those that hold money because inflation reduces the value of their money holdings. T or F?

T

Monetary neutrality means that a change in the money supply doesn't cause a change in anything at all. T or F?

F

Inflation erodes the value of people's wages and reduces their standard of living. T or F?

F

Inflation reduces the relative price of goods whose prices have been temporarily held constant to avoid the costs associated with changing prices. T or F?

T

The shoeleather costs of inflation should be approximately the same for a medical doctor and for an unemployed worker. T or F?

F

Inflation tends to stimulate saving because it raises the after tax real return to saving. T or F?

F

Governments that spend more money than they can raise from taxing or borrowing tend to print too much money which causes inflation. T or F?

F

If inflation turns out to be higher than people expected, wealth is redistributed to lenders from borrowers. T or F?

F

If the nominal interest rate is 7 per cent and the inflation rate is 5 per cent, the real interest rate is 12 per cent. T or F?

F

In the long run, inflation is caused by
a. governments that raise taxes so high that it increases the cost of doing business and, hence, raises prices.
b. banks that have market power and refuse to lend money.
c. none of these answers.
d. governments that print too much money.
e. increases in the price of inputs, such as labour and oil.

D

When prices rise at an extraordinarily fast rate, it is called
a. disinflation.
b. deflation.
c. hyperinflation.
d. inflation.
e. hypoinflation.

C

If the price level doubles,
a. the quantity demanded of money falls by half.
b. the value of money has been cut by half.
c. nominal income is unaffected.
d. none of these answers.
e. the money supply has been cut by half.

B

In the long run, the demand for money is most dependent upon
a. the level of prices.
b. the interest rate.
c. the availability of banking outlets.
d. the availability of credit cards.

A

The quantity theory of money concludes that an increase in the money supply causes
a. a proportional increase in prices.
b. a proportional increase in real output.
c. a proportional decrease in velocity.
d. a proportional increase in velocity.
e. a proportional decrease in prices.

A

An example of a real variable is
a. the wage rate in euros.
b. None of these answers are real variables.
c. the price of corn.
d. the nominal interest rate.
e. the ratio of the value of wages to the price of soda.

E

The quantity equation states that
a. money 3 real output = velocity 3 price level.
b. money 3 velocity = price level 3 real output.
c. none of these answers.
d. money 3 price level = velocity 3 real output.

B

If money is neutral,
a. an increase in the money supply does nothing.
b. a change in the money supply only affects real variables such as real output.
c. a change in the money supply reduces velocity proportionately; therefore there is no effect on either prices or real output.
d. a change in the money supply only affects nominal variables such as prices and wages.
e. the money supply cannot be changed because it is tied to a commodity such as gold.

D

If the money supply grows 5 per cent, and real output grows 2 per cent, prices should rise by
a. 5 per cent.
b. more than 5 per cent.
c. less than 5 per cent.
d. none of these answers.

C

The velocity of money is
a. highly unstable.
b. impossible to measure.
c. the rate at which money loses its value.
d. the rate at which inflation rises.
e. the rate at which money changes hands.

E

Countries that employ an inflation tax do so because
a. the government doesn't understand the causes and consequences of inflation.
b. government expenditures are high and the government has inadequate tax collections and difficulty borrowing.
c. an inflation tax is the most progressive (paid by the rich) of all taxes.
d. an inflation tax is the most equitable of all taxes.
e. the government has a balanced budget.

B

An inflation tax
a. is usually employed by governments with balanced budgets.
b. none of these answers.
c. is an explicit tax paid quarterly by businesses based on the amount of increase in the prices of their products.
d. is a tax borne only by people who hold interest bearing savings accounts.
e. is a tax on people who hold money.

E

Suppose the nominal interest rate is 7 per cent while the money supply is growing at a rate of 5 per cent per year. If the government increases the growth rate of the money supply from 5 per cent to 9 per cent, the Fisher effect suggests that, in the long run, the nominal interest rate should become
a. 9 per cent.
b. 11 per cent.
c. 4 per cent.
d. 16 per cent.
e. 12 per cent.

B

If the nominal interest rate is 6 per cent and the inflation rate is 3 per cent, the real interest rate is
a. none of these answers.
b. 3 per cent.
c. 6 per cent.
d. 18 per cent.
e. 9 per cent.

B

If actual inflation turns out to be greater than people had expected, then
a. no redistribution occurred.
b. wealth was redistributed to lenders from borrowers.
c. the real interest rate is unaffected.
d. wealth was redistributed to borrowers from lenders.

D

Which of the following costs of inflation does not occur when inflation is constant and predictable?
a. Costs due to inflation induced tax distortions.
b. Arbitrary redistributions of wealth.
c. Shoeleather costs.
d. Menu costs.
e. Costs due to confusion and inconvenience.

B

Suppose that, because of inflation, a business in Russia must calculate, print, and mail a new price list to its customers each month. This is an example of
a. shoeleather costs.
b. costs due to confusion and inconvenience.
c. arbitrary redistributions of wealth.
d. costs due to inflation induced tax distortions.
e.
menu costs.

E

Suppose that, because of inflation, people in Brazil economize on currency and go to the bank each day to withdraw their daily currency needs. This is an example of
a. costs due to inflation induced relative price variability which misallocates resources.
b. menu costs.
c. shoeleather costs.
d. costs due to inflation induced tax distortions.
e. costs due to confusion and inconvenience.

C

If the real interest rate is 4 per cent, the inflation rate is 6 per cent, and the tax rate is 20 per cent, what is the after tax real interest rate?
a. 5 per cent
b. 2 per cent
c. 1 per cent
d. 3 per cent
e. 4 per cent

B

Which of the following statements is true about a situation where real incomes are rising at 3 per cent per year.
a. None of these answers is true.
b. If money is neutral, an increase in the money supply will not alter the rate of growth of real income.
c. All of these answers are true.
d. If inflation were 0 per cent, people should receive raises of about 3 per cent.
e. If inflation were 5 per cent, people should receive raises of about 8 per cent per year.

C

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