# Econ Chapter 12

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### Calculate the Price

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 Over the past 70 years, prices in the US have risen about 4 precent Over the past 70 years, te overall price level in the US has experience 16 fold increase Over the past 70 years, the average annual US inflation rate was about 4 precent, implying prices increased a 16 fold Inflation can be measured by the percentage in the consumer price index. When prices are falling, economists say there is a deflation Deflation decreases incomes and reduces the ability of debtors to pay off their debts If the price index in some country were falling over time, economists would say that country had deflation The term hyperinflation refers to a predict of very high inflation Economists agree that high inflation is costly, but they disagree about the costs of moderate inflation. Inflation is more about the value of money than about the value of goods The value of money falls as the price level riss, because the number of dollars needed to buy a representative basket of good rises. If P denotes the price of goods and services measures in terms of money, then 1/P represents the value of money measured in terms of goods and services. When we assume that the supply of money is a variable that the central bank controls, we are ignoring the complications introduced by the role of the banking system. With the value of money on the vertical axis, the money supply curve is vertical When the money market is drawn with the value of money on the vertical axis, a decrease in the price level causes a movement to the left alone the money demand curve When the money market is drawn with the value of money on the vertical axis, if the Federal reserve buys bonds, then the money supply curve shifts right, causing the price level to rise When the money market is drawn with the value of money on the vertical axis, if the Federal Reserve sells bonds, the money supply curve shifts left, causing the price level to fall and the value of money to rise When the money market is drawn with the value of money on the vertical axis, if the money demand shifts leftwards, then there is an initial excess in demand, causing price level to fall The price level falls if either money demand shifts rightwards of money supply shifts leftward. The price level rises if either money demand shifts leftwards or money supply shifts rightward; the rise in the price level is associated with a fall in the value of money. As the price level rises, the value of money falls, and people desire to hold more of it (because dollar is worth less and they need more to purchase stuff) Money demand depends on the price level and the interest rate If M= 3,000, P=2, and Y=12,000, what is velocity? 8 If M= 10,000, P=2, and Y=20,000, what is velocity? 4. Velocity will rise if the money changes hands more frequently. If velocity = 5, the price level = 1.5, and the real value output is 2,500, then the quantity of money is 750.00 If velocity = 3.5, quantity of money = 15,000 and the price level = 1.2, then the real value of output 43,750 According to te classical dichotomy, which of the following is affected by monetary factors? Nominal wages, The price level, Nominal GDP, ALL OF THE ABOVE. Almost all nominal including GDP and price level Other things the same, an increase in velocity means that the rte at which money changes hands rises, so the price level rises According to the quantity theory of money, a 2 precent increase in the money supply causes the price level to rise by 2 precent see graph to understand The inflation tax refers to the revenue a government creates by printing money If the nominal interest rate is 8 precent and the expected in flatten is 3.5, then what is the real interest rate? 4.5 8-3.4 REAL = NOM – INFLATION Which of the following combinations of real interest rates and inflation implies a nominal interest rate of 7 precent? a real interest rate of 6 and inflation of 1 precent REAL = NOM – INFLATION 7 = real + interest To explain the long run determinants of the price level and the inflation rate, most economists today rely on the quantity theory of money The quantity theory of money can explain both moderate inflation and hyperinflation As the price level decreases, the value of money increases, so people want to hold less of it An increase in the price level makes the value of money decrease, so people want to hold more of it When the price level falls, the number of dollars needed buy a representative basket of goods decreases, so the value of money rises When the price level rises, the number of dollars needed to buy a representative basket of goods, increase, and so the value of money falls The supply of money is determined by the Federal Reserve System The supply curve of money is vertical because the quantity of money supplied increases only if the central banks increase the money supply The money supply increases when the FED makes an open market purchase Money demand refers to how much wealth people want to hold in liquid form When the market is drawn with the value of money on the vertical axis, the money demand curve solves downward, because at higher prices people want to hold more money. (to be able to pay high prices) When the market is drawn with the value of money on the vertical axis, as the price level increases the quantity off money demanded increases When the market is drawn with the value of money on the vertical axis, an increase in. the price level causes movement to the right along the money demand curve When the market is drawn with the value of money on the vertical axis, as price level increases, the value of money decreases, so the quantity of money demand increases When the market is drawn with the value of money on the vertical axis, money demand slopes downward and money supply slopes horizontal. When the money market is drawn with the value of money on the vertical axis, long-run equilibrium is obtained when the quantity demanded and quantity supplied of money are equal due to adjustment in the value of money value of money = equilibrium When the money market is drawn with the value of money on the vertical axis, if the price level is above the equilibrium level, there is an excess in demand for money, so the price level falls When the money market is drawn with the value of money on the vertical axis, if the value of money is below equilibrium level, the value of money will rise Suppose the money market, drawn with the value of money on the vertical axis, is the equilibrium. If the money supply increases, then at the old value of money there is an excess in supply which results in an increase spending because dollar is worth less Which is correct? If the Fed makes purchases of bonds, then the value of money supply curve shifts right. A change in the price level des not shift the money supply curve. When the money market is drawn with the value of money on the vertical axis, an increase in the money supply shifts the money supply curve to the right, rising price levels If the Fed increases the money supply, then 1/P falls, so the value of money rises 1/P = VALUE OF MONEY When the money market is drawn with the value of money on the vertical axis, an increase in the money supply, increases the price level and decreases the value of money When the money market is drawn with the value of money on the vertical axis, an increase in the money supply causes the equilibrium value of money to decrease, while the equilibrium quantity of money increases When the money market is drawn with the value of money on the vertical axis, if the Fed sells bonds then the money supply and the price level decreases When the money market is drawn with the value of money on the vertical axis, if there is an surplus of money then the value of money falls which will make people desire to hold more money. When the money market is drawn with the value of money on the vertical axis, if the money supply rises the price level rises and the value of money falls When the money market is drawn with the value of money on the vertical axis, the price level increases is money demand shifts left or money supply shifts right When the money market is drawn with the value of money on the vertical axis, the price level decreases if money demand shifts right or money supply shifts left When the money market is drawn with the value of money on the vertical axis, the price level increases if money demand shifts left and decreases if the money supply shifts left Open market purchases by the FED make the money supply increase, which makes the value of money decreases Consider the money market drawn with the value of money on the vertical axis. If the money demand is unchanged and the price level rises, then the money supply must have increased, perhaps because the FED bought bonds. In the fourteenth century, the Western African Emperor Kahn Musa traveled to Cairo where he gave away much gold, which was in use as a medium of exchange. We would predict the this increase in gold based the price level, but decrease the value of gold in Cairo SUPPLY SHFTS RIGHT In the 1970’s in response t the recessions caused by an increase in the price of oil, the central banks in many countries increases their money supply. The central banks might have done this by purchasing bonds in the open market, which have lowered the value of money When the money market is drawn with the value of money on the vertical axis, an increase in the money supply creates an excess in supply o money, causing people to spend more because the value went down A decrease in the money supply creates an excess demand for money that is eliminated by falling prices (because value of money goes up) Suppose there is a surplus in the money market, This could have been created by an increase in the money supply. The value of money will fall. The price level falls. This might be because the Federal Reserve self bonds with reduced the money supply Economic variables whose values are measured in monetary unites are calles nominal variables Economic variables measured in goods are real variables On a given morning, Franco sold 40 pairs of shoes for a total of \$80 at his shoe store. The \$80 is the nominal variable and the 40 pairs are the real variable Nominal GDP measures the dollar value of the economy’s output of final goods and services The price level is nomina variable The price of a Honda Accord is a nominal variable, and the price of a Honda Accord divided by the price of a Honda Civic is a real variable. when compared its real, alone is nominal When shopping you notice that a pair of jeans costs \$20 and that the tee-shrt costs \$10. You compute the price of jeans relative to the tee-shirts. The dollar price of the jeans is nominal; the relative price of Jens is a real variable when compared its real, alone is nominal An associate professor of hyoids gets a \$200 a month raise. She figures that with her new monthly salary she can buy more goods and services than she could buy last year. Her real and nominal salary have risen because compares toast year salary it went up so the comparison ( the real ) went up as well as the nominal .. obviously An assistant manager ast a restaurant gest a \$100 a month raise. He figures that with his new monthly salary he cannot buy as many goods and services as he could last year. His nominal salary went up but his real salary has fallen Your boss gives you an increase I the number of ollas you earn per hour. This increase in pay makes your nominal wage increase. If your nominal wage rose by a greater percentage than the price level, then your real wage has also increases. Suppose the price level rises, but the number of dollars you are paid pero hour stays the same. This means your real wage is lower Suppose each good costs \$5 per unit and Megan holds \$40. What is the real value of the money she holds? 8 unites of goods. If the price of goods rises, to maintain the real value of her money holdings she needs to hold more dollars. On its website, you bank posts the interest rates it its paying on savings account. Those rates and a price index are both nominal variables. -they are not comparing or anything… but themselves they are nominal Interest rates adjusted for the effects of inflation are real variables, inflation is a nominal variable -inflations by itself is nominal, but since compared or adjusted, the interest is REAL. You put money in the bank. The increase in the dollar value of your savings is a nominal variable, but the change in the number of goods you can buy with your savings is a real variable. The idea that nominal variables are heavily influenced by the quantity of money and that money is largely irrelevant for understanding the determinants of the real variables is called the classical dichotomy The classical dichotomy refers to the idea that the supply of money determined nominal variables, but not the real variables. The classical dichotomy argues that changes in the money supply affect nominal variables, but not real variables According to the classical dichotomy, which of the following increases when the money supply increases? Price level According to the classical dichotomy, which of the following is influenced by monetary factors? nominal intrest rates According to the classical dichotomy, which of the following is influenced by monetary factors? the nominal wage According to the classical dichotomy, which of the following is NOT influenced by monetary factors? Real GDP -only nominal GDP According to the classical dichotomy, which of the following is NOT influenced by monetary factors? real wage and real GDP Changes in nominal variables are determined mostly by the quantity of money and the monetary system according to both classical dichotomy and the quantity theory or money According to the classical dichotomy, when the money supply doubles, which of the following also doubles? the price level and nominal wages – both are affected by the ditchomy and nominal variables of monetary factors According to the classical dichotomy, when the money supply doubles, which of the following also doubles? the price level and the nominal GDP – both are affected by the ditchomy and nominal variables of monetary factors The principle of monetary neutrality implies that an increase in the money supply increases the price level, but not the real GDP real GDP is the value of money According to the principle of money neutrality, a decrease in the money supply will to change unemployment – wtf thats diffrent Monetary neutrality implies that an increase in the quantity of money sill increase the price level Most economists believe the principle of money neutrality is mostly relevant to the long run Most economists live that monetary neutrality provides a good description of the long run, but not short run According to classical dichotomy, when money supply doubles, which doubles? price level, nominal wages and nominal GDP Which of the following is correct? When studying the long run changes in the economy, the neutrality of money offers a good description of how the world works. The velocity of money is the average umber of times pero year a dollar is spent Velocity is computed (PxY)/M Based on the quantity equation, if M=100, V=3, and Y=200, then P= 1.5 Based on the quantity equation, if M=150, V=4, and Y=200, then P= 3 Based on the quantity equation, if P=1.5, M= 4,000, and Y=6,000, then V= 2.25 According to the quantity equation, if P = 2, Y=6000, and M=3,000, then V= 4 According to the quantity equation, the price level would change less than proportionately with a rise in the money supply if there were also either a rise in output or a fall in velocity. MxV=PxY Accord to the assumption of quantity theory of money, if the money supply increases by 5 precent, then Price level would rise by 5% and GDP would be unchanged MxV=PxY Accord to the assumption of quantity theory of money, if the money supply increases by 5 precent, then nominal GDP would rise by 5, real GDP would be unchanged Velocity is (PxY)/M and increases if the dollar exchanged more frequently If Y and V are constants, and M doubles, the quantity equation implies that the price level doubles M x V = P x Y 2 x 1 = P x 1 2=P If Y and M are constants, and V doubles, the quantity equation implies that the price level doubles M x V = P x Y 1 x 2 = P x 1 2=P If V and M are constants, and Y doubles, the quantity equation implies that the price level falls to half of its original value M x V = P x Y 1 x 1 = P x 2 1 = P2 1/2 = P If velocity and output were nearly constant, then the inflation rate would be about the same as the money supply growth rate. Suppose that velocity Rises while the money supply stays the same. It follows that M x 2 = P x Y 1 x 2 = P x Y P and Y must rise The only supply in Muckland is \$100 billion. Nominal GDP is \$800 Billion and real GDP is \$400 billion. What is the price level and velocity in Muckland? M x V = P x Y 100V = P400 V=P400/100 V=P4 V has to be 8; P has to be 2 Suppose the money supply tripled, but at the same time velocity fell by half and the real GDP was unchanged. According to the quantity equation, the price level is 1.5 times its old value M x V = P x Y 3 x (1/2) = P x 1 1.5 = P Suppose the money supply tripled, but at the same time velocity fell by half and the real GDP doubled. According to the quantity equation, the price level M x V = P x Y 3 x (1/2) = P x 2 1.5 = P2 0.75=P 0.75 times its old value Suppose the money supply tripled, but at the same time velocity was unchanged and the real GDP doubled. According to the quantity equation, the price level M x V = P x Y 3 x 1 = P x 2 1.5 = P 1.5 its old value If real output in an economy is 1,000 goods per year, the money supply is \$300, and each dollar is spent an average of 3 times per year, the account to the quantity equation, the average price level is M x V = P x Y 300 x 3= P x 1,000 900 = P1000 0.90 = P Suppose monetary neutrality holds and velocity is constant. A 5 precent increase in the money supply M x V = P x Y %5 increase = increases P by %5 -money supply and price level go together Suppose than when the money supply changes, real output and velocity do not change. Then a 2% increase in the money supply increases price level by 2% -money supply and price level go together Which of the following is NOT implied by the quantity equation? With the constant money supply and velocity, an increase n output creates a proportional increase in the price level. FALSE If money is neutral is stable, and increase in the money supply creates a proportional increase in both price level and nominal output nominal output too because its multiplying it Evidence of hyperinflation indicates that money growth and inflation are positively related, which is consistent with the quantity theory of money. When the money supply and the price level in countries that experienced hyperinflation are plotted on a graph against time, we see that price level grew at a constant rate as the money supply The source of hyper inflation is primarily increases in the money supply growth Based on past experience, if a country is experiencing hyperinflation, then which of the following would be a reasonable guess? The country has a high money supply growth, Inflation is acting like a tax on everyone who holds money, the government is printing money to finance its expenditures, all of the above. Inflation tax is Gov printing more money, an alternative to income taxes and gov borrowing, taxes most those who hold the most money, all of the above. Gov may prefer an inflation tax to some other type of tax because inflation tax is easier to impose Inflation falls most on people who have a lot of money and people who have accounts for small share of US government revenue. Printing money to finance government issues imposes a tax on everyone who holds money. Which of the following is correct? The congress used the inflation tax to help finance the AMERICAN rEVOLUTION Suppose the US unexpectedly decided to pay off its debt by printing new money. Which of the following would happen? people who hold more money would be poorer, prices go up, people who had lent money at a ixed rate would feel poorer The claim that increases the growth rate of the money supply increases nominal interest rates but not real interest rates is known as Fisher Effact The real interest rate is 8% and the nominal interest rate is 10.5%. Is there inflation or deflation? What is the inflation or deflation rate? R=N-I 8=10.5 – i i=2.5 inflation 2.5 Bob puts money in a savings account at her bank earning 3.5%. onE YEAR LATER SHE TAKES THE MONEY OUT AND NOTES HER MONEY WAS EARNING INTREST, prices rose 1.5%. Bob earned a nominal intrest rate of. nominal of 3.5 precent (fact, given) inflation rate of 2% 3.5 – 1.5 = 2 2 is the increase, the real is 2% Shawn puts money into an account. One year later he sees that he has 5% more dollars and is money will buy 6% more goods. The nominal interest rate was 5% and the inflation rate was -1 5-6 = -1 he can buy more Kate puts money into an account. One year later he sees that he has 6% more dollars and is money will buy 2% more goods. nom is 6, inflation is 4 Banks advertise the nominal interest rate, which is how fast the dollar value of savings grows. If a country experienced deflation the real interest rate should be greater than the nominal interest rate. Fisher effect nominal interest rates adjust on for one with the inflation rate. Under the assumption of the Fisher Effect and monetary neutrality, if the supply growth rate rises, then the nominal rises but the real interest rate does not Under the assumption of the Fisher Effect and monetary neutrality, if the supply growth rate falls, then the nominal falls but the interest rate does not When money is neutral, which of the following increases the money supply growth rate increases? nominal interest rates Suppose the monetary neutrality and the Fisher effect both hold and the money supply growth rate has been the same for a long time. Other things the same, a higher money supply growth rate would be associated with both high inflation and high nominal interest rates Suppose the monetary neutrality and the Fisher effect both hold. An increase in the money supply growth rate increases the inflation and nominal interest rates Suppose the monetary neutrality and the Fisher effect both hold. An increase in the money supply growth rate increases the inflation rate, but not the real interest rate only nominal Suppose the monetary neutrality and the Fisher effect both hold. An increase in the money supply growth rate increases the inflation rate but nor the growth of real GDP. Suppose the monetary neutrality and the Fisher effect both hold. An increase in the money supply growth rate increases the inflation rate and the nominal interest rate by the same percentage points. Suppose the monetary neutrality and the Fisher effect both hold. An increase in the money supply growth rate eventually increases inflation and nom, but not real interest rates The fisher effect says that there is a one for one adjustment of the nominal interest rate to the inflation rate. Inflation in the US 1970 10 % per year Which of the following statements about inflation is correct? Inflation does not in itself reduce poeple’s real purchasing power. Why is the inflation fallacy a fallacy? Because nominal incomes tend to rise at the same time that the price level is rising. The inflation tax is a tax on everyone who holds money People can reduce the inflation tax by reducing cash holdings Shoe leather costs arise when higher inflation rates induce people to hold less money The shoeleather cost of inflation refers to the waste of resources used to maintain lower money holdings Shoeleather costs refer to resources used to maintain lower money holdings when inflation is high. People go to the bank more frequently to reduce currency holdings when inflation is high. The sacrifice of time and convenience that is devoted in doing that is referred to ass shoeleather costs When inflation rises, people tend to go more to the bank to more often, giving the rise to sheleather costs When inflation rises, firms make more frequent price changes. This raises their menu costs. The cost of changing price tags and price listings are known as menu costs -ebay what happened Menu costs refers to the cost of more frequent price changes If there is inflation, then a firm has kept its price fixed for some time will have a lower-relative price. Relative-price variability rises as the inflation rate rises. Relative price variability rises with inflation, leading to a misallocation of resources. Relative-price variability is ‘automatic’ when firms change prices only once in a while. Higher inflation makes relative prices more variable, making it less likely that resources will be allocated to their best use. When inflation causes relative-price variability, consumers decisions are distorted and the ability of markets to effeciently allocate factors of production is impaired. If the inflation rate falls, people are likely to change prices less frequently and go to the bank less frequently When inflation rises, people people make more trips to the bank and firms change more their prices. When inflation rises people desire to hold less money and will go to the bank more frequently U.S. tax laws allow taxpayers, in computing the amount of tax they owe, to use the real value, as opposed to the nominal value, of neither interest nor capital gain In the US, taxes on capital gains are computed using nominal gains. This is one way by which higher inflation discourages savings. In the US, people are required to pay taxes on nominal interest rates, irrespective of their real interest earnings. You bought some shares of stock and, over the next year, the price per share increased by 5 precent, as did the price level. Before taxes, you experienced a nominal gain, but no real gain, and you pay taxes on the nominal gain. because the price level increased but the VALUE decreased. So he has more but it is worth less. You bought some shares of stock and, over the next year, the price per share increased by 5% and the price level increased 8%. Before taxes, you experienced a a nominal gain and a real loss, and you paid taxes on the nominal gain. a real loss because the price level increased more than the nominal gain in value. bigger is price level so real loss, but since there shares increase you have a nominal gain When deciding how much to save, people care most about after tax real interest rates For a given real interest rate, an increase in inflation makes the after-tax real interest rate decrease, which discourages savings Given a nominal interest rate of 8%, in which of the following cases would you earn the highest after-tax real interest rate? inflation is 3 and after tax rate is 40% low inflation % and high tax rate % Given a nominal interest rate of 6%, in which of the following cases would you earn the highest after-tax real interest rate? inflation is 2 and after tax rate is 30% Given a nominal interest rate of 6%, in which of the following cases would you earn the lowest after-tax real interest rate? inflation is 4 and after tax rate is 5% high inflation % and low tax rate % Given a nominal interest rate of 5%, in which of the following cases would you earn the highest after-tax real interest rate? inflation is 3 and after tax rate is 20% inflation is 2 and after tax rate is 40% inflation is 1 and after tax rate is 60% ALL OF THE ABOVE ARE THE SAME You put your money into an account that earns 5% nominal interest rate. The inflation rate is 3%, and your marginal tax rate is 20%. What is your after-tax rate of interest? .20 x 5= 1.0 because it was nominal, you don’t add You put your money into an account that earns 4% real interest rate. The inflation rate is 2%, and your marginal tax rate is 20%. What is your after-tax rate of interest? .20 x 4= 0.8 + 2% = 2.8 because the real was give, you add You put your money into an account that earns 6% real interest rate. The inflation rate is 2%, and your marginal tax rate is 20%. What is your after-tax rate of interest? ? none You put your money into an account that earns 2.5% after tax real interest rate. The nominal interest rate is 8%, and the inflation rate is 2%. What is your tax rate? t boe continued

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