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Inflation and Deflation
1. Suppose that country A and country B have the same rate of money growth, and
velocity is constant in both. Output growth is higher in country A. Which country has
higher inflation? Explain.
ANSWER: According to the quantity equation, the sum of the percentage change in
money supply and the percentage change in velocity have to equal the sum of the
percentage change in the price level and the percentage change in output. This is rep-
2. In Figure 14.1, the relation between money growth and inflation is less perfect
among countries with inflation below 10 percent than it is among countries with higher
inflation. What might explain this difference?
ANSWER: According to the quantity equation, part of the differences in inflation rates
among different countries can be explained by differences in velocity and output
3. Should the United States return to the gold standard? What might be the advan-
tages and disadvantages?
ANSWER: With commodity money, such as gold, the growth of the money supply is
linked to the amount of the commodity produced. This eliminates the risk of high in-
flation and the associated cost and is the major advantage of returning to the gold
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4. [Advanced] Assume that a central bank’s nominal seigniorage revenue equals the
change in the money supply, denoted ΔM. Real seigniorage revenue is ΔM/P. As-
sume the inflation rate equals the growth rate of the money supply, which is ΔM/M
a. What is the rationale for these assumptions? Are they realistic?
ANSWER: Strictly speaking the central bank’s nominal seigniorage revenue equals
ΔMB, the change in the monetary base. Since ΔM= m* ΔMB, nominal seigniorage
b. Write real seigniorage revenue in terms of the inflation rate and the real money
supply, M/P.
ANSWER: Expand the definition of real seignorage revenue: ΔM/P= (ΔM/P)(M/M).
c. When inflation rises, what happens to the real money supply and to seignior-
age revenue? (Hint: In equilibrium, money supply must equal money demand.)
ANSWER: The higher inflation rate increases the first term (ΔP/P) in the definition of
real seigniorage revenue and leads to increased revenue. The second term (M/P)
d. Sometimes a small increase in the government budget deficit produces a large
increase in inflation. Explain this fact using the answer to part (c).
ANSWER: When M/Pfalls, then a relatively small increase in ΔM/Pmust be due to
5. Suppose all firms in an economy adjust prices once per year. Half the firms adjust
prices in January, and half adjust in July. Suppose inflation rises from 0 to 10 percent
per year. What is the likely effect on the variability of relative prices? Explain.
ANSWER: Firms adjust prices because of specific changes in their market (demand
and supply for their specific product) and because of general inflation. Assume that
the market-specific adjustments are the same for the 0 and the 10 percent inflation
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6. Consider the market for loanable funds, which determines the real interest rate in
the long run (see Section 4.1).
a. As usual, draw the supply and demand for loans as functions of the pretax real
interest rate, r.
ANSWER: Figure 4.2 shows the graph of the loanable funds market. The equilibrium
b. Suppose savers are taxed on their nominal interest income. If inflation rises,
what happens to the supply and demand curves in part (a)?
ANSWER: The higher the inflation rate, the lower the after-tax real interest rate for a
given pretax real interest rate. Savers will likely decrease their supply of loanable funds
c. What happens to the equilibrium levels of the pretax real interest rate, loans,
and investment?
7. Suppose the pretax real interest rate (r) is 2 percent, the tax rate (μ) is 0.4, and the
inflation rate (
π
) is 8 percent. Calculate the after-tax real interest rate (r
^).
ANSWER: Equation 14.4 states: r= (1 – τ)r–μ
π
. Given the numerical information:
8. What inflation rate would make the after-tax real interest rate equal the pretax real
rate (that is, what inflation rate implies (r
^)= r)? Explain.
ANSWER: Plugging the definition r= (1 – μ)r– τ
π
into the equation r= rgives
9. Explain the difference between deflation and disinflation.
ANSWER: Deflation is a negative inflation rate. This means that on average, prices
10. “Inflation is always and everywhere a monetary phenomenon, but deflation is
not.” Comment.
ANSWER: The basic mechanism by which an increase in money supply causes in-
flation is captured with the AE/PC model. As money supply increases, the nominal in-
terest rate falls and for constant inflationary expectations, the real interest rate falls.
This lower real rate spurs additional expenditures, moving the economy along the
In the sense that high rates of growth in the money supply cause inflation and low
rates of growth in the money supply cause deflation, one could argue that both infla-
11. How does each of the following events affect the risk of a liquidity trap?
a. The central bank decides to push long-run inflation to zero.
ANSWER: The risk of a liquidity trap increases when the central bank decides to
push long-run inflation to zero. Any shocks to the economy that reduce output will
b. The neutral real interest rate rises (see Section 12.5 for a review of the neu-
tral rate).
ANSWER: The neutral real interest rate rnis the interest rate that makes output equal
potential output. Other things being equal (the inflation rate, for example), the higher
c. The government introduces a tax on people’s holdings of currency. Other as-
sets are not taxed.
ANSWER: The nominal interest rate on holding currency is normally zero. By im-
posing a tax on holding currency, the government is able to reduce the after-tax nom-
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ONLINE AND DATA QUESTIONS
www.worthpublishers.com/ball2
12. Link from the text Web site to the St. Louis Fed site for data on (1) nominal GDP
and (2) interest rates on 3-month Treasury bills. Link to www.sweepmeasures.com for
data on M1 adjusted for sweep accounts (use the series labeled M1RS).
a. Using these data, compute the velocity of money for each year from 1980 to
the present. Make a graph showing velocity and the T-bill rate over time.
ANSWER: Velocity is calculated by dividing nominal GDP by M1 adjusted for sweep
accounts.
b. Does velocity fluctuate from year to year? What might explain these move-
ments?
ANSWER: Velocity is relatively constant at a level of 25 during the 1980s. In the late
c. What is the long-run trend in velocity? What might explain this trend?
ANSWER: The long-run trend has been for velocity to fall. As stated in the text, any
factor that will affect the level of money holdings Mdwill have an impact on velocity.
13. Link from the text Web site to the site of the International Labour Organization,
whose LABORSTA database reports consumer price indices for most of the world’s
countries. For a recent year, identify the country with the highest inflation rate (that
is, the largest percentage change in its price index). Do some research and explain
why inflation is high in that country.
ANSWER: In recent years (through 2010), Zimbabwe was the country with the high-
est inflation worldwide. In 2007 consumer prices increased 24,110 percent with ris-
ing tendency in 2008. The countries with the next highest inflation rates were
Myanmar with 35.02 percent and Venezuela with 18.70 percent. The policies that led
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14. [Advanced] From the St. Louis Fed Web site, get annual data on U.S. inflation
from 1960 to the present.
a. For each decade from the 1960s through the 2000s, calculate the mean and
variance of inflation over the decade. For example, calculate the mean and vari-
ance for the 10 years from 1960 through 1969.
ANSWER: The table below contains the answers for the mean U.S. inflation and vari-
ance for the 5 decades.
Decade Mean Variance
b. Make a graph that plots the mean of inflation against the variance, with a point
for each decade. What is the relation between the two variables?
ANSWER: The graph shows a positive relationship between the mean and the vari-
c. What might explain the relation found in part (b)?
ANSWER: High average levels of inflation also show more variability in inflation rates.
This may be explained by the fact that it is harder to form accurate expectations about
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