978-1259663048 Chapter 34 Solutions Manual

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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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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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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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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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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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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

PC (Pe = 5%)

Long-run

Phillips curve

PC (Pe >5%)

PC (Pe < 5%)

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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(a)

Real output

A D

S A S

L A S

S A S

(b)

Unemployment rate

LRPC

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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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

A D

S A S

L A S

S A S

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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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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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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