Money, Inflation, and Interest Rates


Review Questions

1. What is money?

 

 An asset that is generally accepted as a means of payment.
2. What are the major determinants of money demand?

 

 The volume of transactions, the nominal interest rate, and the cost of converting other assets into money.
3. What is the velocity of money?

 

 Velocity is the number of times each dollar turns over per time period in generating $1 of GDP.
4. What is the Quantity Theory of Money?

 

 A theory according to which variations in the inflation rate are due primarily to variations in the money growth rate.
5. What is meant by the classical dichotomy, or the neutrality of money?

 

 The monetary sector of the economy does not affect the real sector.
6. What is the primary determinant of ongoing inflation?

 

 Ongoing money growth.
7. What are the costs of inflation?

 

 Unintended wealth redistribution and increased transaction costs caused by lower real money holdings.
8. How are the inflation rate, the real interest rate, and the nominal interest rate related to each other? r = i - p

 
9. What causes hyperinflations? Excessive use of money growth as a source of government revenue.

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Answers to Selected Textbook Problems

Mankiw, Macroeconomics, third edition, chapter 6, problems and applications

2. Letting gy and gm denote the growth rates of real GDP and money, respectively, then inflation and the real interest rate are given by
p = gy - gm = 14 - 5 = 9 percent
r = i - p = 11 - 9 = 2 percent

3.
a.
The nominal amount of these benefits is indexed to inflation.
b. No.  Assuming no error in measuring the price index (or that the error in measuring inflation is unrelated to the actual amount of inflation), indexing just does not alter the real value of benefits.

4.
Among the benefits of having one's own currency are the ability to conduct an independent monetary policy (assuming that the foreign exchange rate is allowed to float) and the fact that the revenue from creating this money accrues to the domestic government.  If domestic residents use  the U.S. dollar, then every increase in domestic holdings of dollars allows the U.S. government to print more dollars, which is a source of revenue to the U.S. government.  There is some administrative cost in maintaining a central bank or other monetary authority.  In addition, that central bank might not conduct monetary policy as well as the U.S. Federal Reserve, thus causing excessive and excessively variable inflation.

6.
Inflation erodes the real value of the government's debt liabilities, and is thus similar to an explicit repudiation of the debt.  President Coolidge's statement is only partly true, however, as it applies only to unexpected inflation.  If inflation is fully expected, the borrower (in this case the government) and the lender can simply agree to pay a higher nominal interest rate to offset the effects of inflation in eroding the real value of the principal.  If such an inflation premium is built into the nominal interest rate, then expected inflation does not amount to repudiation.  Unexpected inflation does not affect the nominal interest rate, however.  Therefore, an unexpected inflation lowers the real interest rate on the government debt and is similar to repudiation.

7.
Standard microeconomic theory tells us that supply curves slope upward, i.e., an increase in the relative price (as distinguished from the nominal price) of a good causes more of the good to be produced.  A deflation is a decrease in the general level of money prices of goods and services, which amounts to an increase in the value (purchasing power) of money.  Under a gold standard, the government either allows gold to circulate as money or fixes the price of gold in terms of money.  (The government can do this by standing ready to buy and sell gold at this fixed price.)  Thus, deflation implies an increase in the value of gold in terms of other goods or services, i.e., an increase in the relative price of gold.  This increase in the relative price makes it more profitable to search for and mine gold.