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CHAPTER 34: INFLATION, DEFLATION, AND MACRO
POLICY
Questions and Exercises
1. Asset price inflation occurs when the prices of assets rise more than their “real”
2. False. While inflation does not make society richer or poorer, there are costs. The
3. Three costs of inflation are informational costs, distributional costs and
4. Small amounts of inflation allow nominal prices to rise, which makes workers and
Since the financial crisis of 2008, and the introduction of unconventional
monetary policy, that view about an inflation target as being an upper bound for
inflation has changed. Inflation targets are no longer seen as an upper bound, but
If people had seen the price increase as a one-time event and accepted the
decrease in their real income that it implied, it would not generate an ongoing
inflation. But if the increase became built into expectations, it would have led to
other price increases and resulted in accelerating inflation.
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© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
5. When nominal interest rates get low, expansionary monetary policy is limited by a
zero lower bound--the nominal interest rate cannot fall significantly below zero,
6. A placebo effect works though individual's mind, not through normal medicinal
methods. Because people think it will have an effect, it does, and what is
Goods inflation also keeps the economy away from asset deflation. Since assets
often serve as collateral for loans, significant asset deflation can throw an
economy into a financial crisis, as occurred in 2008 when the prices of housing
Unconventional monetary policy emphasizes that the benefits of low inflation
should receive more emphasis. Low inflation because (low) inflation greases the
7. Lenders lose out because they are paid a fixed nominal interest rate and when
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© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
8. Lenders would not lose out if the interest rate were indexed to inflation, the lender
was able to adjust the interest rate periodically based on the level of inflation, or
9. Asset price inflation redistributes wealth from more cautious to less cautious
individuals. An example is investors. Cautious investors purchase less risky stocks
whose prices are not likely to rise as much as more risky stocks are likely to rise
10. Policymakers have changed their focus because interest rates have been very low,
which compromises the central bank’s ability to stimulate the economy by
lowering interest rates.
An alternative explanation is that when asset deflation hits, it hits suddenly and
hard, as the United States saw in 2008. Once an asset deflation occurs, firms will
11. Zero lower bound is important because it is a limit on how far interest rates can
fall. With interest rates below zero people will shift to holding cash. This lower
An alternative explanation is that with conventional monetary policy,
policymakers face a zero interest rate lower bound—a limit on how much interest
rates can fall. With unconventional monetary policy they do not. Since the
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© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12. Both adaptive and extrapolative expectations are based on past experience.
13. Inflation would be 2 percent (5-3).
14. The three assumptions are that (1) velocity of money is constant, (2) real income
15. Inflation will be 10 percent.
16. a. Real output is $2,000.Use the equation, MV = PQ (500 × 8 = 2Q, so Q = 4,000/2).
b. Nominal output is $4,000. Nominal output is P × Q (2 × 2,000)
c. Rise by 20%. If the money supply rises 20 percent (from 500 to 600), the price
d. If the government established price controls, either shortages would result if the
17. The quantity theory of money is problematic because (1) the relationship between
18. The short-run Phillips curve is illustrated in the accompanying graph. The
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© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Unemployment rate
19. The long-run Phillips curve is shown in the accompanying below as the vertical
Unemployment rate
20. No. If inflation changes but expectations of inflation do not, the economy will
21. a. The economy is at point A on the short-run and long-run Phillips curves on the
b. The answer to this question depends on the state of the economy and the concerns
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
c. The short-run consequences are explained in answers to parts a and b. In the case
of expansionary monetary policy, inflation expectations will rise, which will shift
Unemployment rate
5%
5%
PC (Pe = 5%)
A
Long-run
Phillips curve
C
D
PC (Pe >5%)
B
PC (Pe < 5%)
E
22. a. An increase in productivity shifts the long-run aggregate supply curve to the right
b. An increase in productivity shifts the long-run Philips curve to the left because it
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
(a)
Real output
Y
0
Y
1
A D
0
A D
1
P
0
P
1
S A S
0
L A S
0
L A S
1
S A S
1
A
B
(b)
Unemployment rate
PC
0
A
B
PC
1
LRPC
0
LRPC
1
U
0
i
0
U
1
i
1
Questions from Alternative Perspectives
1. Austrian
a. Many Austrians believe that if the government kept a very low profile, and did not
b. Governments might not stop inflation because of political pressure.
2. Religious
a. There is no objective “just” weight; it is a subjective “just” weight that is backing
b. Inflation can be seen as an injustice because it changes the value of the measure
c. The injustice of inflation is born by those who experience, but did not expect it
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© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3. Institutionalist
a. If you graph this you will see that there are several business cycle oscillations
b. In the AS/AD model the oil shock shifts the SAS curve up, increasing prices and
c. If one uses expansionary fiscal policy, one can prevent the recession, but only at
Real output
Y0
Y1
A D
0
A D
1
P0
P1
S A S
0
L A S
S A S
1
A
B
C
P2
4. Post-Keynesian
a. This is a judgment question and judgments differ. Post-Keynesians believe that
b. Post-Keynesians recommend the use of income policies involving tax and market
c. If one believes that inflation is caused by excess demand, then income policies
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
5. Radical
a. The Radical view emphasizes social conflict between different classes of people;
b. This is a judgment question and judgments differ.
Issues to Ponder
1. a. Stopping inflation tends to transfer money from debtors to creditors. Creditors are
b. Since the exchange rate was fixed, any differential in inflation rates between the
two countries could not be offset by a change in the exchange rate. The fact that
c. When there’s inflation (with interest rates falling behind inflation), people look
d. One reason why luxury auto dealers were shutting down was the same as the
argument given in (a). A second reason is equivalent to that given in (c). A third
2. The advantage of indexing grades is that it provides a benchmark with which to
measure a student’s performance relative to the rest of his or her class. It would
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© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3. It depends. With short-run, long-run, and shifting curves, just about any
combination of inflation and unemployment rates can fit some Phillips curve. So,
4. a. He would likely be a quantity theorist since quantity theorists see inflation most
b. Inflation can affect household decisions in a number of ways. It can add
uncertainty about the future, leading households to save more and make fewer
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© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
