Chapter 16 Homework Inflation Disinflation And Deflation The Economy

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1. In the economy of Scottopia, policy makers want to lower the unemployment rate and

raise real GDP by using monetary policy. Using the accompanying diagram, show why

this policy will ultimately result in a higher aggregate price level but no change in real

GDP.

Aggregate

price

level

LRAS

SRAS1

1. In the accompanying diagram, the economy of Scottopia is in long- run macro-

economic equilibrium at E1. If policy makers want to lower the unemployment rate

and raise real GDP, they will engage in expansionary monetary policy, which will

shift AD1 rightward to AD2. In the short run, equilibrium moves to E2; real GDP is

higher and unemployment is lower. However, the aggregate price level has risen and

over time, as workers are able to renegotiate wages, SRAS1 will shift leftward to SRAS2.

2. In the following examples, would the classical model of the price level be relevant?

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2. a. The classical model of the price level is not well suited to an economy with a great

deal of unemployment and no history of inflation. Increases in aggregate output

can occur without an immediate change in the aggregate price level because it takes

some time for workers and firms to react to changes in the aggregate price level by

3. The Federal Reserve regularly releases data on the U.S. monetary base. You can access

that data at various websites, including the website for the Federal Reserve Bank of

St. Louis. Go to http://research.stlouisfed.org/fred2/ and click on “Categories,” then on

“Money, Banking, & Finance,” then on “Monetary Data,” then on “Monetary Base,”

and then on “Monetary Base; Total” for the latest report. Then click on “View Data.”

3. Answers will vary depending on when you look up the information.

a. From September 2013 to September 2014, the monetary base grew from

$3,486.920 billion to $4,049.181 billion, an increase of $562.261 billion.

4. Answer the following questions about the (real) inflation tax, assuming that the price

level starts at 1.

a. Maria Moneybags keeps $1,000 in her sock drawer for a year. Over the year, the

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c. For a third year, Maria keeps the $1,000 in the drawer. What is the real value of

4. a. The real inflation tax paid is $100 ($1,000 × 0.10).

b. The price level at the end of the first year will be 1 × 1.10 = 1.10. The real value of

$1,000 at the beginning of the second year is $1,000/1.10 = $909.09. So the real

inflation tax paid for the second year is $90.91 ($909.09 × 0.10).

c. The price level at the end of the second year will be 1.10 × 1.10 = 1.21. The real

5. The inflation tax is often used as a significant source of revenue in developing coun-

tries where the tax collection and reporting system is not well developed and tax eva-

sion may be high.

a. Use the numbers in the accompanying table to calculate the inflation tax in the

United States and India (Rp = rupees).

5. a. The inflation tax is equal to: Inflation rate × Money supply. For India, this is

Money supply Central government

Inflation in 2013 receipts in 2013

in 2013 (billions) (billions)

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b. The inflation tax as a percentage of government receipts is 16.9% in

6. The main advantage to printing money to cover the deficit is to avoid the crowding –

out effects—the reduction in private investment spending that occurs due to higher

7. The accompanying scatter diagram shows the relationship between the unemployment

rate and the output gap in the United States from 1996 to 2013. Draw a straight line

through the scatter of dots in the figure. Assume that this line represents Okun’s law:

Unemployment rate = b − (m × Output gap)

where b is the vertical intercept and −m is the slope

Unemployment

rate

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7. The accompanying figure shows a line drawn through the dots relating the unemploy-

ment rate and the output gap for the United States from 1996 to 2013. Your line may

be slightly different from the one drawn here. The line passes through the vertical axis

at an unemployment rate of about 5%, as indicated by point A. So the unemployment

rate when output equals potential output is 5%. At an output gap of 2%, the predicted

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?

8. There are two primary reasons why Albernia is experiencing a jobless recovery, a recov-

ery in which the unemployment rate falls only slowly, if at all. The first reason is that

9. a. Go to www.bls.gov. Click on link “Subjects”; on the left, under “Inflation &

Prices,” click on the link “Consumer Price Index.” Scroll down to the section “CPI

Tables,” and find the link “Consumer Price Index Detailed Report, Tables Annual

Averages 2009 (PDF).” What is the value of the percent change in the CPI from

2008 to 2009?

b. Now go to www.treasury.gov and click on “Resource Center.” From there, click on

“Data and Charts Center.” Then click on “Interest Rate Statistics.” In the scroll-

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9. a. The percent change in the CPI from 2008 to 2009 was −0.4%.

b. In 2009, the Treasury bill 4-week bank discount was very low, with a maximum of

0.26% and a low of 0.01%—virtually zero. In 2007, the equivalent rate was much

higher, with a high of 5.15% and a low of 2.34%. The very low Treasury bill rates in

10. The accompanying table provides data from the United States on the average annual

rates of unemployment and inflation. Use the numbers to construct a scatter plot

similar to Figure 16-5. Discuss why, in the short run, the unemployment rate rises

when inflation falls.

Year Unemployment rate Inflation rate

2003 6.0% 2.3%

2004 5.5 2.7

2005 5.1 3.4

10. The accompanying figure shows a negative relationship between the unemployment rate

and the inflation rate: when the unemployment rate rises, the inflation rate falls. This

should come as no surprise: the short-run aggregate supply curve says that as the aggregate

price level rises (that is, as there is inflation), aggregate output rises. And from Okun’s law

we know that as aggregate output rises above potential output (that is, as the output gap

increases), unemployment falls. In other words, as inflation rises, unemployment falls. So

there is a negative relationship between the inflation rate and the unemployment rate.

Inflation

rate

4.0%

3.0

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11. The economy of Brittania has been suffering from high inflation with an unemploy-

11. A major obstacle to achieving disinflation is that the public has come to expect con-

tinuing inflation. To reduce inflation, it is often necessary to keep the unemployment

rate above the natural rate for an extended period of time so that the public can adjust

its expectations to a lower inflation rate. The harder it is to change the public’s expec-

12. Who are the winners and losers when a mortgage company lends $100,000 to the

Miller family to buy a house worth $105,000 and during the first year prices unex-

12. Over the first year, as prices fall 10%, the value of the Millers’ house will fall from

$105,000 to $94,500. Since they borrowed $100,000 to buy it, the value of the house

is now less than the amount they owe. If they sold the house, they would not be able

to pay off their mortgage. The Millers are worse off. The mortgage company is better

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13. 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

13. Countries such as Japan will find that they can sustain an unemployment rate lower

than the NAIRU for longer periods of time before the expected rate of inflation

increases than can countries such as Zimbabwe. So Japanese monetary and fiscal

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