Chapter 31: Inflation, Disinflation, and Deflation

a.) losers b.) winner c.) 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 would drive the company to lend less. d.) Individuals and firms will be increasingly reluctant to borrow money, since they are afraid that the assets acquired with borrowed funds will become less valuable. Institutions will be more reluctant to lend money because of borrowers' increased default risk.

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%? a.) The Millers are ____ as a result of this deflation. b.) The mortgage company is a ______ as a result of this deflation. c.) What would you expect to happen if the deflation continued over the next few years? d.)How would continuing deflation affect borrowers and lenders throughout the economy as a whole?

a.) ~ Five years of hyperinflation. ~ Recent price stability, natural rate of unemployment. b.) Great deal of unemployment, no infaltion

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% to 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. a.) Classical model relevant b.) Classical model not relevant

a.) INFLATION TAX: 250 = (1000 x .25) b.) REAL VALUE: 800 = (1000 x 1.25) INFLATION TAX: 200 = (800 x .25) c.) REAL VALUE: 640 = (800-160) INFLATION TAX: 160 = {[1000/(1.25)2] x .25} d.) TOTAL TAX: 610 = (250+200+160) e.) Hyperinflation quickly erodes the purchasing power of money.

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? Inflation tax: $____ 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? Real value: $_____ Over the year, the inflation rate is again 25%. What is the real inflation tax paid by Maria for the second year? Inflation tax: $_____ 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? Real value: $____ Over the year, the inflation rate is again 25%. What is the real inflation tax paid by Maria for the third year? Inflation tax: $____ d.) After three years, what is the cumulative real inflation tax paid? Inflation tax: $____ Why is hyperinflation such a problem?

a.) 100 = (1000 x .10) b.) REAL VALUE: 909.09 = (1000/1.10) INFLATION TAX: 90.91 = (909.09 x .10) c.) REAL VALUE: 826.45 = (1000/1.21) INFLATION TAX: 82.65 = (826.45 x .10) d.) TOTAL TAX: 273.56 = (100+90.91+82.65)

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? Inflation tax: $_________ 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? Real value: $__________ Over the year, the inflation rate is again 10%. What is the real inflation tax paid by Maria for the second year? Inflation tax: $___________ 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? Real value: $__________ Over the year, the inflation rate is again 10%. What is the real inflation tax paid by Maria for the third year? Inflation tax: $___________ d.) After three years, what is the cumulative real inflation tax paid? Inflation tax: $_______

~ Advantage : Avoids crowding out ~ Disadvantage : Increases inflation

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

~ 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 re-entered 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.

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 as much, although the economy was experiencing strong economic growth? Select all accurate explanations.

WORK IT OUT/////////////////////// Both countries experience a vertical Phillips curve in the long run.

Due to historical differences, countries often differ in how quickly a change in actual inflation is incorporated into a change in expected inflation. In a country such as Japan, which has had very little inflation in recent memory, it will take longer for a change in the actual inflation rate to be reflected in a corresponding change in the expected inflation rate. In contrast, in a country such as Zimbabwe, which has recently had very high inflation, a change in the actual inflation rate will immediately be reflected in a corresponding change in the expected inflation rate. Which of the following statements is true in regards to the short-run and long-run Phillips curves in these two types of countries?

deflation

During periods of _____, people are eager to hold large sums of money.

increase real GDP only in the short run, and raise the price level in the long run.

If nominal wages are slow to adjust to changes in the price level, then the effect of an increase in the money supply is to:

increase by the same percentage as

In the long run, an increase in the money supply will cause nominal prices and nominal wages to _____ the percentage increase in the money supply.

2

In this graph, SRPC1 is the short-run Phillips curve for this economy when the expected inflation rate equals 0%. Using the graph, the short-run Phillips curve (SRPC) equals SRPC2 when the expected inflation rate equals _____%.

negatively; less than one-to-one

Okun's law finds that output gaps and unemployment rates are _____ related in a _____ ratio.

the end of persistently high inflation.

One of the benefits of disinflation is:

decreased gross domestic product.

One of the costs of disinflation is:

a.) Holders of money b.) U.S. Treasury c.) Holders of Treasury Securities d.) Federal Reserve

Please match each of the descriptions with the corresponding organization or group. a.) Who bears the full burden of the "inflation tax?" b.) Who is responsible for issuing U.S. debt in order to finance the government's purchases? c.) Who sells government debt back to the federal government through open-market transactions? d.) Who buys back government debt through open-market purchases?

economists who worked before 1920.

The classical model of the price level reflects the work of:

aggregate demand curve shifted to the right.

The economy would move up a fixed Phillips curve to a higher unemployment rate and a lower inflation rate if the:

vertical

The long-run Phillips curve is _____ at the nonaccelerating inflation rate of unemployment.

QUIZ Q'S//////////////////////// classical model

The notion that the real quantity of money is always at its long-run equilibrium level is associated with the _____ of the price level.

Inflation Expectations

The relationship between inflation and unemployment in the short run is different from their relationship in the long run. ~ Which of the following is an important factor in that difference?

decreases.

The short-run Phillips curve shifts downward if expected inflation:

short-run aggregate supply curve shifts to the left.

The short-run Phillips curve would shift upward if the:

True

The worst inflation in the United States in modern times occurred in the late 1970s, when prices were increasing at an annual rate of 13%.

deflation; more than

When _____ occurs, a dollar in the future is worth _____ a dollar today.

is less than

When actual output is greater than potential output, the actual unemployment rate _____ the natural rate of unemployment.

is below the natural rate.

When the output gap is positive, the unemployment rate:

a vertical curve

Which shape accurately portrays the long-run Phillips curve?

It is a reduction of the inflation.

Which statement accurately describes disinflation?

lenders

Who gains when there is unexpected deflation?

Deflation

_____ refers to a falling aggregate price level.

~ Federal Reserve ~ buy ~ paying off that amount

b.) How does the change in the monetary base help in the government's efforts to finance its deficits? ~ The increase in the monetary base was created by the _____ and used to ______ government secutities—in effect _______ of government debt by printing money.

shift downward.

If expected inflation decreases, then the short-run Phillips curve will:

END OF CHAPTER////////////////// GRAPH : AD shifts RIGHT SRAS shifts LEFT EQ shifts UP

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.

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.

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 they minimize the unemployment cost of disinflation? Is it possible for there to be no cost of disinflation?

INFLATION TAX: a.) UNITED STATES: 3.70 = (.0012 x 3082) INDIA: 1442.90 = (.0587 x 24581) b.) US: 0.12% = (3.70/3082) x 100 INDIA: 11.63% = (1442.90/12409) x 100

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:___

inflation and unemployment.

A Phillips curve implies a negative relationship between:

LEARNING CURVE//////////////////// long-run equilibrium.

According to the classical model, the real quantity of money is always at its:

no change in the unemployment rate.

According to the text, in the long run, an increase in the inflation rate will lead to:

fall

An economy is in equilibrium at the natural rate of unemployment, and government spending decreases. In the long run, the inflation rate MOST likely will:

rise

An economy is in equilibrium at the natural rate of unemployment, and government spending increases. In the long run, the inflation rate MOST likely will:

HOMEWORK Q'S/////////////////////// it has no effect on GDP GRAPH : SRAS shifts LEFT AD shifts RIGHT

Assume that the United States government introduces an expansionary monetary policy, increasing the money supply in the market. In the accompanying graph, demonstrate the long run effect on aggregate demand and short run aggregate supply. Then, answer the following question. In the classical model of the price level, what is the long run effect of an increase in the money supply on real GDP?

real; nominal

Borrowers and lenders should base their decisions on the _____ rate of interest and not the _____ rate of interest.

occurs when borrowers reduce their aggregate spending, because the deflation increases the debt burden that borrowers experience.

Debt deflation:

~ Inflation : Characterized by an overall rise in prices. Has become the norm for economies since WWII ~ Both : The Philips curve shed light on his phenomenon. ~ Deflation : Characterized by overall drop in prices. Leads to a liquidity trap when interest rates approach zero.

Determine whether each of the statements describes inflation, deflation, or both. ~ Inflation ~ Both ~ Deflation

inflation.

Disinflation refers to a decrease in:

policy may plunge the economy into a recession.

Disinflation:

Monetary and fiscal policy will be effective only in the short run for Japan and not Zimbabwe.

Due to historical differences, countries often differ in how quickly a change in actual inflation is incorporated into a change in expected inflation. In a country such as Japan, which has had very little inflation in recent memory, it will take longer for a change in the actual inflation rate to be reflected in a corresponding change in the expected inflation rate. In contrast, in a country such as Zimbabwe, which has recently had very high inflation, a change in the actual inflation rate will immediately be reflected in a corresponding change in the expected inflation rate. What does this imply about the effectiveness of monetary and fiscal policy in reducing the unemployment rate?

short-run aggregate supply; right

If expected inflation decreases, then the _____ curve will shift to the _____.

10; returns to the potential level of output

If the monetary authorities decide to increase the nominal money supply by 10% when the economy is at its full-employment level of output, in the long run the aggregate price level increases by _____% and real GDP _____.

$180 million.

If the money held by the public is $3 billion and inflation is 6%, the inflation tax is:

$4 billion.

If the money supply grows by 4% and the real money supply is $100 billion, real seignorage is:

16

If the money supply is $800 billion and inflation is 2%, then the inflation tax is $_____ billion.

inflation will increase.

If the natural rate of unemployment is 5% and the actual rate of unemployment is 4%:

shift downward; decrease by 2%

In the United States, if there is a decrease in the expected inflation rate of 2%, then the short-run Phillips curve will _____ and the actual inflation rate will _____.

public expects deflation.

Liquidity traps are most likely to occur when the:

4%.

Refer to Figure 16-4: Actual and Natural Rates of Unemployment. In 1982, the cyclical unemployment rate was approximately:

E1 to E3, ignoring E2; increases; remains the same

Refer to Figure: AD-AS. Suppose that the economy starts at E1 and moves to E2, where AD2 intersects SRAS1. Finally, the economy moves to E3. The classical model of price level assumes that the economy moves from _____; thus, inflation _____ and real GDP _____.

rise to 2%.

Refer to Figure: Expected Inflation and the Short-Run Phillips Curve. Suppose that this economy has an unemployment rate of 6%, no inflation, and no expectation of inflation. If the central bank increases the money supply such that aggregate demand shifts to the right and unemployment falls to 4%, then inflation will:

equal to the natural rate of unemployment.

Suppose that actual aggregate output is equal to the potential output; the actual unemployment rate is:

a.) GRAPH : ~ AD shifts RIGHT ~ Output will remain the same. b.) GRAPH : ~ Point A shifts to 5 ~ Unemployment will remain the same.

Suppose that, in the next year, the government plans to use monetary policy to decrease interest rates. In Graph 1, adjust the proper curve or curves appropriately to show the effect of the policy change. In Graph 2, move Point A to show what will happen to inflation in the long run as a result of the movement in Graph 1. a.) What happens to output as a result of the change in interest rates in the long run? b.) What happens to unemployment as a result of the change in the interest rates in the long run?

a.) Borrowers are negatively impacted and lenders are positively impacted. b.) GRAPH : AD shifts LEFT

Suppose there is unexpected deflation this year that reduces the aggregate price level. The economy is depicted in the accompanying graph. a.) How does deflation affect borrowers and lenders? b.) Adjust the graph to show the effect of the deflation.

classical

The _____ model helps to explain long-run economic fluctuations.

~ GRAPH : shifts down to 3% ~ 7%

The accompanying graph depicts a hypothetical economy's short-run Philips curve . Please adjust the SRPC to reflect what happens when expected inflation decreases by 2 % points. After the shift in the SRPC, what is the unemployment rate if the public expects no inflation in the economy?

a.) 3% b.) GRAPH: SRPC shifts up to 5% c.) 5%

The accompanying graph depicts the Short-Run Phillips Curve (SRPC) when the public expects no inflation in the economy. a.) According to this SRPC, what would inflation be if unemployment is 1 %? b.) Please move the SRPC line to reflect what would happen if the public's inflation expectations increased so that they now expect the inflation rate to increase by 2%. c.) If the unemployment rate is still 1 %, what is the new inflation rate after this change in expectations?

DISCOVERING DATA////////////////////// $ 47,922

The accompanying graph plots the size of the monetary base in the United States over time. a.) What was the absolute change in the monetary base between 2014 and 2015? $___million

more accurate in periods of high inflation than in periods of low inflation.

The classical model is:

contractionary

To achieve disinflation, stabilization policy should be:

a.) ~ By printing money to pay its debt, government decreases the value of money and causes the inflation tax. ~The federal government reserve the power to print money. b.) the revenue from printing money

Using your knowledge of the inflation tax to answer the questions. a.) Which of the statements are true regarding the inflation tax? b.) Seignorage refers to

a.) a change in the output gap occurs with a change in the rate of unemployment that is smaller in magnitude and in the opposite direction. b.) An increase in real GDP of 4% leads to a decrease in the unemployment rate of 2%.

a.) Okun's law states that b.) Which is a prediction consistent with Okun's law?

a.) When nominal interest rates cannot be lowered any further. b.) Firms are unlikely to undertake investment during liquidity traps because interest rates are prohibitively high.

a.) What is a liquidity trap? b.) Which of these statements about liquidity traps is false?

If not indepentent, then the government might be tempted to have the central bank print more money (creating inflation) whenever the government runs a budget deficit.

c.) Why is it important for the central bank to be independent from the part of the government responsible for spending?