ECON 202 Chapter 12

Bertha purchased 10 shares of BestSnack, Inc. stock for $200 per share; in one year, she sold the 10 shares for $220 a share. Over the year, the inflation rate was 3%. If the tax rate on nominal capital gain is 50%, how much tax does Bertha pay on her gain?

$100; The cost of reduced money holdings due to high inflation rates is called the 'shoeleather cost' of inflation. People must make more frequent trips to the bank to get more cash, which, supposedly, causes shoes to wear out more quickly.

Bertha bought 10 shares of iSnack stock for $1 per share. In one year, she sold 5 shares for $5 a share. During this year, the price level increased from 140 to 147. What is Bertha's before-tax real capital gain?

$19; The inflation rate is 100 x ((147 - 140)/140) = 5%. Bertha paid $5 for five shares last year. Now, she sold them for $5 per share, making 5 x $5 = $25 while gaining $25 - $5 = $20. Of her $20 gain, 5% is lost to inflation: $20 - $20 x 0.05 = $19

Consider an economy producing only widgets, which cost $2 each. If you have $100, what is the real value of the money you hold?

50 widgets. If the price of widgets increases, you will need more money; Real variables are measured in physical units. Thus in real terms, $100 is equivalent to $100/$2 = 50 widgets. When the price level rises, the dollars in your wallet are less valuable because you can afford fewer widgets.

The nominal interest rate is 8%, inflation is 1%, the marginal income tax rate is 10%. What is after-tax real rate of interest?

6.2%; The government takes 10% of the nominal rate of 8%, leaving an after-tax nominal interest rate of only 8% - (8% x 0.10) = 7.2%. Thus the after-tax real interest rate is 7.2% - 1% = 6.2%

Suppose P is the price level (the GDP deflator), Y the quantity of output (real GDP), and M the quantity of money. If M = 1,000, P = 2, and Y= 3,000, what is velocity (V)?

6; MV= PY

The nominal interest rate is 12%, inflation is 3%, the marginal income tax rate is 10%. What is after-tax real rate of interest?

7.8%; The government takes 10% of the nominal rate of 12%, leaving an after-tax nominal interest rate of only 12% - (12% x 0.10) = 10.8%. Thus the after-tax real interest rate is 10.8% - 3% = 7.8%.

Suppose P denotes the price of goods and services measured in terms of money.

A decrease in the value of money is associated with an increase in P.

In the U.S., people are required to pay taxes on real capital gains irrespective of their nominal capital gains.

False

There are no costs of deflation.

False; Deflation causes the value of debts to increase in real terms, transferring money from debtors to creditors. It also has menu costs and relative price variability.

The immediate effect of a monetary injection increases the economy's ability to supply goods and services.

False; The immediate effect of a monetary injection is an excess supply of money.

When inflation was expected to be high and it turns out to be low, wealth is redistributed from creditors to debtors.

False; Unexpected changes in prices redistribute wealth among debtors and creditors.

As the price level increases, the value of money increases.

False; when more money is printed the money value decreases

Bertha took out a 5-year fixed-interest-rate loan. She has anticipated the inflation rate of 3% but it actually turned to be only 2%.

Her real interest rate was higher than expected, and the real value of the loan is higher than expected.

Bertha took out a 5-year fixed-interest-rate loan. She has anticipated the inflation rate of 2% but it actually turned to be 4%.

Her real interest rate was lower than expected, and the real value of the loan is lower than expected.

Which of the following is true about inflation and relative prices?

Higher inflation increases the relative-price variability distorting the resource allocation.

Which of the following reforms would allow for the taxation of only real interest earnings?

Indexing the tax system to take into account the effects of inflation

Which of the following is true about the inflation tax in the United States?

It falls most heavily on those who hold a lot of currency but accounts for a small share of U.S. government revenue.

Why do people believe in the inflation fallacy?

People tend to forget that inflation in prices goes hand in hand with inflation in incomes; When prices rise, buyers of goods and services are worse off but at the same time, sellers are better off

Which of the following explains why the demand curve for money is downward sloping?

People want to hold a larger quantity of money when each dollar buys less.

Which of the following describes how inflation can be measured?

Percentage change in the GDP deflator; Inflation is measured as a percentage change in the consumer price index (CPI), the GDP deflator, or some other index of the overall price level.

When higher inflation reduces the value of money,

Shoeleather costs of inflation increase; The cost of reduced money holdings due to high inflation rates is called the 'shoeleather cost' of inflation. People must make more frequent trips to the bank to get more cash, which, supposedly, causes shoes to wear out more quickly.

Which of the following describes the effect of a decrease in the money supply?

The money supply curve shifts to the left, the price level decreases causing the value of money to increase.

Which of the following describes the effect of an increase in the money supply?

The money supply curve shifts to the right, the price level increases causing the value of money to decrease.

Which of the following is the immediate effect of a monetary injection?

The money supply increases, whereas the economy's ability to supply goods and services does not change.

Which of the following describes the Fisher effect?

The nominal interest rate adjusts to the inflation rate

Which of the following explains why the supply curve for money is vertical?

The quantity of money supplied is fixed by the Federal Reserve

Which of the following describes the money equilibrium in the long run?

The quantity of money that people want to hold equals the quantity of money supplied by the Fed.

Which of the following theories can explain both inflation and hyperinflation?

The quantity theory of money

Which of the following theories explains the long-run determinants of the price level and the inflation rate?

The quantity theory of money

An increase in the value of money decreases the price of goods and services measured in terms of money.

True

In the U.S., the income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.

True

When deciding how much to save, people care most about before-tax nominal interest rates.

True

When inflation rises, the nominal interest rate rises, and people desire to hold less money

True

When inflation turns out to be higher than expected, wealth is redistributed from lenders to borrowers.

True; Higher than expected inflation makes borrowers better off at the expense of the lenders because it diminishes the real value of the debt

When inflation was expected to be high and it turns out to be low, wealth is redistributed from debtors to creditors.

True; Unexpected changes in prices redistribute wealth among debtors and creditors. Lower than expected inflation makes lenders (creditors) better off at the expense of the borrowers (debtors) because it increases the real value of the debt as the real interest rate is the difference between the nominal interest rate and the inflation rate.

Which of the following describes the meaning of the demand for money?

Wealth that people want to hold in liquid form.

The principle of monetary neutrality implies that

an increase in the money supply will increase the price level, but not real GDP; The classical dichotomy implies that changes in the supply of money affect nominal variables but not real ones.

As inflation rises,

menu costs and shoeleather costs of inflation increase

The inflation tax is not exactly like other taxes because ____

no one receives a bill from the government for the tax.

Which of the following describes how inflation is usually measured?

percentage change in the consumer price index

During the 1770s, the United States ____

relied heavily on the inflation tax.

Bertha owns a pastry shop and café in an economy that is prone to rapid inflation. If Bertha reprints her menu every month,

she bears a high menu cost and the relative price of her pastries is to high; inflation distorts relative prices

Which of the following is an example of menu costs?

stores advertising new prices

One cost of deflation is ____

the redistribution of wealth toward creditors and away from debtors

As the price level decreases,

the value of money increases

As the price level increases,

value of money decreases

Suppose the Consumer Price Index has increased from 100 to 105. What is the inflation rate?

5%; Inflation is measured as a percentage change in the overall price level: 100 x ((105 - 100)/100) = 5%

Bertha bought 10 shares of iSnack stock for $1 per share. In one year, she sold 5 shares for $5 a share. During this year, the price level decreased from 147 to 140. What is Bertha's before-tax real capital gain?

$21; The inflation rate is 100 x ((140 - 147)/147) = -5%. Bertha paid $5 for five shares last year. Now, she sold them making 5 x $5 = $25, gaining $25 - $5 = $20. However, since the price level has decreased, Bertha is actually gaining more: $20 - ($20 x (-0.05)) = $21

Bertha purchased 100 shares of BestSnack, Inc. stock for $20 per share; in one year, she sold the 100 shares for $25 a share. Over the year, the inflation rate was 3%. If the tax rate on nominal capital gain is 50%, how much tax does Bertha pay on her gain?

$250; Bertha's capital gain is ($25 - $20) x 100 = $500, of which the government takes 50%, leaving her with $500 x (1 - 0.50) = $250. Note that the remaining 3% is taken by inflation, not the government

Bertha purchased 10 shares of BestSnack, Inc. stock for $200 per share; in one year, she sold the 10 shares for $220 a share. Over the year, the inflation rate was 3%. If the tax rate on nominal capital gain is 50%, how much does Bertha earn?

$97; Bertha's capital gain is ($220 - $200) x 10 = $200, of which the government takes 50%, leaving her with $200 x (1 - 0.50) = $100. Of this amount, inflation takes another 3%: $100 x (1 - 0.03) = $97.

Suppose the nominal interest rate is 8%, the inflation rate is 3% and the tax rate is 45%. What is after-tax real rate of interest?

1.4%; The government takes 45% of the nominal rate of 8%, leaving an after-tax nominal interest rate of only 8% - (8% x 0.45) = 4.4%. Thus the after-tax real interest rate is 4.4% - 3% = 1.4%.

Suppose the Consumer Price Index has increased from 105 to 107. What is the inflation rate?

1.9%; Inflation is measured as a percentage change in the overall price level: 100 x ((107 - 105)/105) = 1.9%

The real interest rate is 4%, inflation is 2%, and the marginal income tax rate is 25%. What is after-tax real rate of interest?

2.5%; The income tax treats this entire nominal interest of 4% + 2% = 6% as income, the government takes 25% of it, leaving an after-tax nominal interest rate ofonly 6% - (6% x 0.25) = 4.5%. The after-tax real interest rate is 4.5% - 2% = 2.5%.

Bertha purchased 100 shares of BestSnack, Inc. stock for $20 per share; in one year, she sold the 100 shares for $25 a share. Over the year, the inflation rate was 3%. If the tax rate on nominal capital gain is 50%, how much did Bertha earn?

242.5; Bertha's capital gain is ($25 - $20) x 100 = $500, of which the government takes 50%, leaving her with $500 x (1 - 0.50) = $250. Of this amount, 3% is lost to inflation, which means that Bertha earns only $250 x (1 - 0.03) = $242.5.

The real interest rate is 5%, inflation is 3%, and the marginal income tax rate is 25%. What is after-tax real rate of interest?

3%; The income tax treats this entire nominal interest of 5% + 3% = 8% as income, the government takes 25% of it, leaving an after-tax nominal interest rate of only 8% - (8% x 0.25) = 6%. The after-tax real interest rate is 6% - 3% = 3%

The nominal interest rate is 10%, inflation is 4%, the marginal income tax rate is 25%. What is after-tax real rate of interest?

3.5%; The government takes 25% of the nominal rate of 10%, leaving an after-tax nominal interest rate of only 10% - (10 x 0.25) = 7.5%. Thus the after-tax real interest rate is 7.5% - 4% = 3.5%.

Suppose the price level has increased from 103 to 107. Which of the following is the inflation rate?

3.88%; Inflation is measured as a percentage change in the overall price level: 100 x ((107 - 103)/103) = 3.88%

Suppose P is the price level (the GDP deflator), Y the quantity of output (real GDP), V is velocity, and M the quantity of money if M = 600, V = 5, and Y = 1000, what is the price level?

3; MV=PY

Suppose the nominal interest rate is 6% and the inflation rate is 2%. What is the real interest rate?

4%

Which of the following describes the relationship between the value of money and the price level?

As the price level falls, the value of money rises

Which of the following describes the relationship between the value of money and the price level?

As the price level rises, the value of money falls.

Which of the following describes monetary neutrality?

Changes in the supply of money affect nominal variables but not real ones.

Bertha lends $1,000 to Danko for 2 years and charges an annual interest rate of 6%. Bertha had anticipated the inflation rate of 2%, but it actually turned to be 2.5%. In two years, as a result of the higher-than-expected inflation,

Danko is better off at the expense of Bertha; Higher than expected inflation makes borrowers better off at the expense of the lenders because it diminishes the real value of the debt