Questions for Review
1. Money has three functions: it is a store of value, a unit of account, and a medium of
exchange. As a store of value, money provides a way to transfer purchasing power from
the present to the future. As a unit of account, money provides the terms in which
prices are quoted and debts are recorded. As a medium of exchange, money is what we
use to buy goods and services.
2. Fiat money is established as money by the government but has no intrinsic value. For
example, a U.S. dollar bill is fiat money. Commodity money is money that is based on a
commodity with some intrinsic value. Gold, when used as money, is an example of com-
modity money.
Pnow represents the price of one unit of output, so that P×Yis the dollar value of out-
put—nominal GDP. Vrepresents the income velocity of money—the number of times a
dollar bill becomes a part of someone’s income.
5. If we assume that velocity in the quantity equation is constant, then we can view the
quantity equation as a theory of nominal GDP. The quantity equation with fixed veloci-
ty states that
CHAPTER 4Money and Inflation
Chapter 4 Money and Inflation 25
6. The holders of money pay the inflation tax. As prices rise, the real value of the money
that people hold falls—that is, a given amount of money buys fewer goods and services
since prices are higher.
7. The Fisher equation expresses the relationship between nominal and real interest
rates. It says that the nominal interest rate iequals the real interest rate rplus the
inflation rate π:
i= r+ π.
8. The costs of expected inflation include the following:
a. Shoeleather costs.Higher inflation means higher nominal interest rates, which
mean that people want to hold lower real money balances. If people hold lower
money balances, they must make more frequent trips to the bank to withdraw
money. This is inconvenient (and it causes shoes to wear out more quickly).
b. Menu costs.Higher inflation induces firms to change their posted prices more
often. This may be costly if they must reprint their menus and catalogs.
There is an additional cost to unexpected inflation:
f. Arbitrary redistributions of wealth. Unexpected inflation arbitrarily redistributes
wealth among individuals. For example, if inflation is higher than expected,
debtors gain and creditors lose. Also, people with fixed pensions are hurt because
their dollars buy fewer goods.
9. Hyperinflation is always a reflection of monetary policy. That is, the price level cannot
grow rapidly unless the supply of money also grows rapidly; and hyperinflations do not
end unless the government drastically reduces money growth. This explanation, howev-
er, begs a central question: Why does the government start and then stop printing lots
have produced a larger total quantity of goods and services, valued in base-year dollars.
As another example, the real interest rate measures the increase in your purchasing
power, the quantity of goods and services you can buy with your dollars, while the nom-
inal interest rate measures the increase in the amount of current dollars you possess.
Problems and Applications
1. Money functions as a store of value, a medium of exchange, and a unit of account.
a. A credit card can serve as a medium of exchange because it is accepted in
exchange for goods and services. A credit card is, arguably, a (negative) store of
2. The real interest rate is the difference between the nominal interest rate and the infla-
tion rate. The nominal interest rate is 11 percent, but we need to solve for the inflation
rate. We do this with the quantity equation expressed in percentage-change form:
% Change in M+ % Change in V= % Change in P + % Change in Y.
Rearranging this equation tells us that the inflation rate is given by:
% Change in P= % Change in M+ % Change in V – % Change in Y.
Substituting the numbers given in the problem, we thus find:
% Change in P= 14% + 0% – 5%
= 9%.
Thus, the real interest rate is 2 percent: the nominal interest rate of 11 percent minus
the inflation rate of 9 percent.
4. The money demand function is given as
a. To find the average inflation rate the money demand function can be expressed in
terms of growth rates:
% growth
M
d
– % growth
P
= % growth
Y
.
26 Answers to Textbook Questions and Problems
M
P
kY
d
Ê
Ë
Áˆ
¯
˜=.
b. From the answer to part (a), it follows that an increase in real income growth will
result in a lower average inflation rate. For example, if real income grows at 6
percent and money supply growth remains at 12 percent, then inflation falls to 6
percent. In this case, a larger money supply is required to support a higher level of
GDP, resulting in lower inflation.
5. The major benefit of having a national money is seigniorage—the ability of the govern-
ment to raise revenue by printing money. The major cost is the possibility of inflation,
or even hyperinflation, if the government relies too heavily on seigniorage. The benefits
6. A paper weapon might have been effective for all the reasons that hyperinflation is bad.
For example, a large increase in the money supply increases shoeleather and menu
costs; it makes relative prices more variable; it alters tax liabilities in arbitrary ways; it
increases variability in relative prices; it makes the unit of account less useful; and
finally, it increases uncertainty and causes arbitrary redistributions of wealth. If the
hyperinflation is sufficiently extreme, it can undermine the public’s confidence in the
economy and economic policy.
Note that if foreign airplanes dropped the money, then the government would not
receive seigniorage revenue from the resulting inflation, so this benefit usually associ-
ated with inflation is lost.
7. The money demand function is given as
8. One way to understand Coolidge’s statement is to think of a government that is a net
debtor in nominal terms to the private sector. Let Bdenote the government’s outstand-
ing debt measured in U.S. dollars. The debt in real terms equals B/P, where Pis the
Chapter 4 Money and Inflation 27
M
P
LiY Y
i
d
Ê
Ë
Áˆ
¯
˜=
()
=,.
5
9. Deflation is defined as a fall in the general price level, which is the same as a rise in
the value of money. Under a gold standard, a rise in the value of money is a rise in the
value of gold because money and gold are in a fixed ratio. Therefore, after a period of
deflation, an ounce of gold buys more goods and services. This creates an incentive to
look for new gold deposits and, thus, more gold is found after a period of deflation.
10. An increase in the rate of money growth leads to an increase in the rate of inflation.
Inflation, in turn, causes the nominal interest rate to rise, which means that the oppor-
tunity cost of holding money increases. As a result, real money balances fall. Since
money is part of wealth, real wealth also falls. A fall in wealth reduces consumption,
and, therefore, increases saving. The increase in saving leads to a rightward shift of the
The classical dichotomy states that a change in a nominal variable such as infla-
tion does not affect real variables. In this case, the classical dichotomy does not hold;
the increase in the rate of inflation leads to a decrease in the real interest rate. The
Fisher effect states that i= r+ π. In this case, since the real interest rate rfalls, a 1-
percent increase in inflation increases the nominal interest rate iby less than 1 per-
cent.
Most economists believe that this Mundell–Tobin effect is not important because
real money balances are a small fraction of wealth. Hence, the impact on saving as
illustrated in Figure 4–1 is small.
11. The
Economist
magazine has a useful Web site for tracking recent economic data
(www.economist.com), although to access some data requires a paid subscription.
28 Answers to Textbook Questions and Problems
and growth of
M
3 was 22 percent. Note that countries with higher rates of inflation
have higher nominal interest rates. To show that countries with higher rates of money
growth have higher rates of inflation is more difficult and requires gathering data on
inflation and money growth across a range of years. Money growth can vary substan-
tially from year to year within a country, and this is not always immediately reflected
in the inflation rate.
More Problems and Applications to Chapter 4
1. With constant money growth at rate µ, the question tells us that the Cagan model
implies that pt= mt+
γ
µ. This question draws out the implications of this equation.
a. One way to interpret this result is to rearrange to find:
mt– pt= –
γ
µ.
That is, real balances depend on the money growth rate. As the growth rate of
money rises, real balances fall. This makes sense in terms of the model in this
chapter, since faster money growth implies faster inflation, which makes it less
desirable to hold money balances.
Chapter 4 Money and Inflation 29