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1.
Describe the functions of money.
2.
What is fiat money? What is commodity money?
3.
Who controls the money supply and how?
4.
Write the quantity equation and explain it.
5.
What does the assumption of constant velocity
imply?
6.
Who pays the inflation tax?
7.
If inflation rises from 6 to 8 percent, what hap-
pens to real and nominal interest rates according
to the Fisher effect?
Q U E S T I O N S F O R R E V I E W
8.
List all the costs of inflation you can think of,
and rank them according to how important you
think they are.
9.
Explain the roles of monetary and fiscal policy
in causing and ending hyperinflations.
10.
Define the terms “real variable” and “nominal
variable,” and give an example of each.
P R O B L E M S A N D A P P L I C A T I O N S
1.
What are the three functions of money? Which
of the functions do the following items satisfy?
Which do they not satisfy?
a. A credit card
b. A painting by Rembrandt
c. A subway token
2.
In the country of Wiknam, the velocity of
money is constant. Real GDP grows by 5
percent per year, the money stock grows by 14
percent per year, and the nominal interest rate is
11 percent. What is the real interest rate?
3.
A newspaper article once reported that the U.S.
economy was experiencing a low rate of
inflation. It said that “low inflation has a down-
side: 45 million recipients of Social Security and
other benefits will see their checks go up by just
2.8 percent next year.”
a. Why does inflation affect the increase in
Social Security and other benefits?
b. Is this effect a cost of inflation, as the article
suggests? Why or why not?
4.
Suppose a country has a money demand function
(M/P)
d
= kY, where k is a constant parameter.
C H A P T E R 4
Money and Inflation
| 115
The money supply grows by 12 per year, and real
income grows by 4 percent per year.
a. What is the average inflation rate?
b. How would inflation be different if real
income growth were higher? Explain.
c. Suppose, instead of a constant money demand
function, the velocity of money in this econ-
omy was growing steadily because of financial
innovation. How would that affect the infla-
tion rate? Explain.
5.
Suppose you are advising a small country (such
as Bermuda) on whether to print its own money
or to use the money of its larger neighbor (such
as the United States). What are the costs and
benefits of a national money? Does the relative
political stability of the two countries have any
role in this decision?
6.
During World War II, both Germany and Eng-
land had plans for a paper weapon: they each
printed the other’s currency, with the intention
of dropping large quantities by airplane. Why
might this have been an effective weapon?
7.
Suppose that the money demand function takes
the form
(M/P)
d
= L(i, Y ) = Y/(5i)
a. If output grows at rate g, at what rate will the
demand for real balances grow (assuming
constant nominal interest rates)?
b. What is the velocity of money in this
economy?
c. If inflation and nominal interest rates are con-
stant, at what rate, if any, will velocity grow?
d. How will a permanent (once-and-for-all)
increase in the level of interest rates affect the
level of velocity? How will it affect the subse-
quent growth rate of velocity?
8.
Calvin Coolidge once said that “inflation is repu-
diation.’’ What might he have meant by this? Do
you agree? Why or why not? Does it matter
whether the inflation is expected or unexpected?
9.
Some economic historians have noted that dur-
ing the period of the gold standard, gold discov-
eries were most likely to occur after a long
deflation. (The discoveries of 1896 are an exam-
ple.) Why might this be true?
10.
Suppose that consumption depends on the level
of real money balances (on the grounds that real
money balances are part of wealth). Show that if
real money balances depend on the nominal
interest rate, then an increase in the rate of
money growth affects consumption, investment,
and the real interest rate. Does the nominal
interest rate adjust more than one-for-one or
less than one-for-one to expected inflation?
This deviation from the classical dichotomy
and the Fisher effect is called the Mundell–Tobin
effect. How might you decide whether the
Mundell–Tobin effect is important in practice?
11.
Use the Internet to identify a country that has
had high inflation over the past year and another
country that has had low inflation. (Hint: One
useful Web site is http://www.economist.com/
markets/indicators/.) For these two countries,
find the rate of money growth and the current
level of the nominal interest rate. Relate your
findings to the theories presented in this chapter.
A P P E N D I X
116
The Cagan Model: How Current
and Future Money Affect the
Price Level
In this chapter we showed that if the quantity of real money balances demand-
ed depends on the cost of holding money, the price level depends on both the
current money supply and the future money supply. This appendix develops the
Cagan model to show more explicitly how this relationship works.
13
To keep the math as simple as possible, we posit a money demand function
that is linear in the natural logarithms of all the variables. The money demand
function is
m
t
− p
t
= −
g
( p
t
+1
− p
t
),
(A1)
where m
t
is the log of the quantity of money at time t, p
t
is the log of the price
level at time t, and
g
is a parameter that governs the sensitivity of money demand
to the rate of inflation. By the property of logarithms, m
t
− p
t
is the log of real
money balances, and p
t+1
− p
t
is the inflation rate between period t and period
t
+ 1. This equation states that if inflation goes up by 1 percentage point, real
money balances fall by
g
percent.
We have made a number of assumptions in writing the money demand func-
tion in this way. First, by excluding the level of output as a determinant of money
demand, we are implicitly assuming that it is constant. Second, by including the
rate of inflation rather than the nominal interest rate, we are assuming that the
real interest rate is constant. Third, by including actual inflation rather than
expected inflation, we are assuming perfect foresight. All of these assumptions are
made to keep the analysis as simple as possible.
We want to solve Equation A1 to express the price level as a function of cur-
rent and future money. To do this, note that Equation A1 can be rewritten as
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