EOC31: End of Chapter Problems - Ch. 31: Inflation, Disinflation, and Deflation

4. Answer the following questions about the (real) inflation tax, assuming that the price level starts at 1.Round answers to two places after the decimal point when necessary. Do not round intermediate calculations of the price level. a. Maria Moneybags keeps $1,000 in her sock drawer for a year. Over the year, the inflation rate is 10%. What is the real inflation tax paid by Maria for this year? b. Maria continues to keep the $1,000 in her drawer for a second year. What is the real value of this $1,000 at the beginning of the second year? Over the year, the inflation rate is again 10%. What is the real inflation tax paid by Maria for the second year? c. For a third year, Maria keeps the $1,000 in the drawer. What is the real value of this $1,000 at the beginning of the third year? Over the year, the inflation rate is again 10%. What is the real inflation tax paid by Maria for the third year? d. After three years, what is the cumulative real inflation tax paid?

Inflation tax: $ 100 Real value: $ 909.09 Inflation tax: $ 90.91 Real value: $ 826.45 Inflation tax: $ 82.65 Inflation tax: $ 273.56

4 e. Redo question 4 with an inflation rate of 25% and answer the following questions. Round answer to two places after the decimal point when necessary. Do not round intermediate calculations of the price level. a. Maria Moneybags keeps $1,000 in her sock drawer for a year. Over the year, the inflation rate is 25%. What is the real inflation tax paid by Maria for this year? b. Maria continues to keep the $1,000 in her drawer for a second year. What is the real value of this $1,000 at the beginning of the second year? Over the year, the inflation rate is again 25%. What is the real inflation tax paid by Maria for the second year? c. For a third year, Maria keeps the $1,000 in the drawer. What is the real value of this $1,000 at the beginning of the third year? Over the year, the inflation rate is again 25%. What is the real inflation tax paid by Maria for the third year? d. After three years, what is the cumulative real inflation tax paid? Why is hyperinflation such a problem?

Inflation tax: $ 250 Real value: $ 800 Inflation tax: $ 200 Real value: $ 640 Inflation tax: $ 160 Inflation tax: $ 610 Hyperinflation quickly erodes the purchasing power of money.

6. Concerned about the crowding-out effects of government borrowing on private investment spending, a candidate for president argues that the United States should just print money to cover the government's budget deficit. What are the advantages and disadvantages of such a plan? Some items may be neither an advantage nor a disadvantage and should not be placed under either heading. Advantage Disadvantage

Advantage Avoids crowding out Disadvantage Increases inflation

2. In the following examples, would the classical model of the price level be relevant? There is a great deal of unemployment in the economy and no history of inflation. The economy has just experienced five years of hyperinflation. Although the economy experienced inflation in the 10%-20% range three years ago, prices have recently been stable, and the unemployment rate has approximated the natural rate of unemployment. Place each situation according to whether the classical model is relevant in that situation. Classical model relevant: Classical model not relevant:

Classical model relevant: Five years of hyperinflation Recent price stability, natural rate of unemployment. Classical model not relevant: Great deal of unemployment, no inflation.

8. After experiencing a recession for the past two years, the residents of Albernia were looking forward to a decrease in the unemployment rate. Yet after six months of strong positive economic growth, the unemployment rate has fallen only slightly below what it was at the end of the recession. How can you explain why the unemployment rate did not fall much, although the economy was experiencing strong economic growth? Select all accurate explanations.

Companies may react to a sudden increase in demand by having workers work longer hours rather than hiring new workers. People who had previously left the labor force have now reentered in order to find work. If the size of the labor force increases at about the same rate as the number of employed workers, the unemployment rate will stay more or less the same.

11. The economy of Brittania has been suffering from high inflation with an unemployment rate equal to its natural rate. Policy makers would like to disinflate the economy at the lowest economic cost possible. Assume that the state of the economy is not the result of a negative supply shock. How can officials minimize the unemployment cost of disinflation? Is it possible for there to be no cost of disinflation?

The unemployment cost of disinflation can be mitigated by government credibility. The more the public believes that the government's policies will reduce inflation, the less unemployment will need to be imposed to adjust public expectations of inflation. Costless disinflation is possible but unlikely—it would only be possible if expectations about inflation shifted immediately after the announcement of the government's plan.

5. The inflation tax is often used as a significant source of revenue in developing countries where the tax collection and reporting system is not well-developed and tax evasion may be high. a. Use the numbers in the accompanying table to calculate the inflation tax in the United States and India (Rp = rupees). Enter your answers in billions of dollars or rupees and round all answers to the nearest tenth. U.S. inflation tax: $ _____________________ billion Indian inflation tax: Rp ______________ billion b. How large is the inflation tax for the two countries when calculated as a percentage of government receipts? United States: ___________________ % India: ___________________ %

U.S. inflation tax: $ 3.70 billion Indian inflation tax: Rp 1442.90 billion United States: 0.12 % India: 11.63 %

1. In the economy of Scottopia, policy makers want to lower the unemployment rate and raise real GDP by using monetary policy. In the accompanying diagram, shift the AD, LRAS, and/or SRAS curves and move the equilibrium point to its new position to show why this policy will ultimately result in a higher aggregate price level but no change in real GDP.

line SRAS shifts to the left and line AD shifts to the right, point E moves to new intersection.

12. Suppose a mortgage company lends $100,000 to the Miller family to buy a house worth $105,000. Who are the winners and losers if, during the first year, prices unexpectedly fall by 10%? The Millers are ___________________ as a result of this deflation. The mortgage company is a _____________________ as a result of this deflation. What would you expect to happen if the deflation continued over the next few years? How would continuing deflation affect borrowers and lenders throughout the economy as a whole?

losers winners Assuming wages fall with the deflation, the Millers would have increasing trouble making their mortgage payments and would eventually default on the loan. The mortgage company would receive a house valued significantly below the amount of money they had lent to the Millers; fear of similar episodes will drive the company to lend less. Individuals and firms would be increasingly reluctant to borrow money since they are afraid that the assets acquired with borrowed funds will become less valuable. Institutions would be more reluctant to lend money because of borrowers' increased default risk.