Name: __________________________ Date: _____________

1.The rate of inflation is the:

A) median level of prices.
B) average level of prices.
C) percentage change in the level of prices.
D) measure of the overall level of prices.

2.The definition of the transactions velocity of money is:

A) money multiplied by prices divided by transactions.
B) transactions divided by prices multiplied by money.
C) money divided by prices multiplied by transactions.
D) prices multiplied by transactions divided by money.

3.If there are 100 transactions in a year and the average value of each transaction is $10,
then if there is $200 of money in the economy, transactions velocity is ______ times per
year.
A) 0.2
B) 2
C) 5
D) 10

4.If the transactions velocity of money remains constant while the quantity of money
doubles, the:
A) price of the average transaction must double.
B) number of transactions must remain constant.
C) price of the average transaction multiplied by the number of transactions must
remain constant.
D) price of the average transaction multiplied by the number of transactions must
double.

5.The quantity equation, viewed as an identity, is a definition of the:

A) quantity of money.
B) quantity of transactions.
C) price level.
D) transactions velocity of money.

6.The income velocity of money:

A) is defined in the identity MV = PY.
B) is defined in the identity MV = PT.
C) is the same thing as the transactions velocity of money.
D) is the same as the number of times a dollar bill changes hands.
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 7.The transactions velocity of money indicates the _____ in a given period, while the
income velocity of money indicates the _____ in a given period.
A) number of transactions; amount of income earned
B) quantity of money used for transactions; quantity of money paid as income
C) number of times a dollar bill changes hands; number of times a dollar bill enters
someone's income
D) volume of transactions; flow of income

8.Real money balances equal the:

A) sum of coin, currency, and balances in checking accounts.
B) amount of money expressed in terms of the quantity of goods and services it can
purchase.
C) number of dollars used as a medium of exchange.
D) quantity of money created by the Federal Reserve.

9.If the average price of goods and services in the economy equals $10 and the quantity of
money in the economy equals $200,000, then real balances in the economy equal:
A) 10.
B) 20,000.
C) 200,000.
D) 2,000,000.

10.The demand for real money balances is generally assumed to:

A) be exogenous.
B) be constant.
C) increase as real income increases.
D) decrease as real income increases.

11.If the quantity of real money balances is kY, where k is a constant, then velocity is:
A) k.
B) 1/k.
C) kP.
D) P/k.

12.If the demand for real money balances is proportional to real income, velocity will:
A) increase as income increases.
B) increase as income decreases.
C) vary directly with the interest rate.
D) remain constant.

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 13.When the demand for money parameter, k, is large, the velocity of money is ______ and
money is changing hands ______
A) large; frequently
B) large; infrequently
C) small; frequently
D) small; infrequently

14.Consider the money demand function that takes the form (M/P)d = kY, where M is the
quantity of money, P is the price level, k is a constant, and Y is real output. If the money
supply is growing at a 10 percent rate, real output is growing at a 3 percent rate, and k is
constant, what is the average inflation rate in this economy?
A) 3 percent
B) 7 percent
C) 10 percent
D) 13 percent

15.The income velocity of money increases and the money demand parameter k ______
when people want to hold ______ money.
A) increases; more
B) increases; less
C) decreases; more
D) decreases; less

16.The quantity equation for money, by itself:

A) may be thought of as a definition for velocity of money.
B) implies that the velocity of money is constant.
C) implies that the price level is proportional to the money supply.
D) implies that real gross domestic product (GDP) is proportional to the money supply.

17.The quantity theory of money assumes that:

A) income is constant.
B) velocity is constant.
C) prices are constant.
D) the money supply is constant.

18.If income velocity is assumed to be constant, but no other assumptions are made, the
level of ______ is determined by M.
A) prices
B) income

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C) transactions
D) nominal GDP

19.If velocity is constant and, in addition, the factors of production and the production
function determine real GDP, then:
A) the price level is proportional to the money supply.
B) real GDP is proportional to the money supply.
C) the price level is fixed.
D) nominal GDP is fixed.

20.In the long run, according to the quantity theory of money and the classical
macroeconomic theory, if velocity is constant, then ______ determines real GDP and
______ determines nominal GDP.
A) the productive capability of the economy; the money supply
B) the money supply; the productive capability of the economy
C) velocity; the money supply
D) the money supply; velocity

21.According to the quantity theory of money, ultimate control over the rate of inflation in
the United States is exercised by:
A) the Organization of Petroleum Exporting Countries (OPEC).
B) the U.S. Treasury.
C) the Federal Reserve.
D) private citizens.

22.According to the quantity theory of money, if money is growing at a 10 percent rate and
real output is growing at a 3 percent rate, but velocity is growing at increasingly faster
rates over time as a result of financial innovation, the rate of inflation must be:
A) increasing.
B) decreasing.
C) 7 percent.
D) constant.

23.If the money supply increases 12 percent, velocity decreases 4 percent, and the price level
increases 5 percent, then the change in real GDP must be ______ percent.
A) 3
B) 4
C) 9
D) 11

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 24.Percentage change in P is approximately equal to the percentage change in:
A) M.
B) M minus percentage change in Y.
C) M minus percentage change in Y plus percentage change in velocity.
D) M minus percentage change in Y minus percentage change in velocity.

25.Using average rates of money growth and inflation in the United States over many
decades, Friedman and Schwartz found that decades of high money growth tended to
have ______ rates of inflation and decades of low money growth tended to have ______
rates of inflation.
A) high; high
B) high; low
C) low; low
D) low; high

26.Using decade-long data across countries from 20002010, countries with high money
growth tend to have _____ inflation.
A) high
B) low
C) constant
D) decreasing

27.The right of seigniorage is the right to:

A) levy taxes on the public.
B) borrow money from the public.
C) draft citizens into the armed forces.
D) print money.

28.Inflation tax means that:

A) as the price level rises, taxpayers are pushed into higher tax brackets.
B) as the price level rises, the real value of money held by the public decreases.
C) as taxes increase, the rate of inflation also increases.
D) in a hyperinflation, the chief source of tax revenue is often the printing of money.

29.The inflation tax is paid:

A) only by the central bank.
B) by all holders of money.
C) only by government bond holders.
D) equally by every household.

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 30.The percentage of government revenue raised by printing money has usually accounted
for:
A) more than 10 percent of government revenue in the United States.
B) less than 3 percent of government revenue in the United States.
C) less than 3 percent of government revenue in Italy.
D) less than 3 percent of government revenue in Greece.

31.During the American Revolution, the price of gold measured in continental dollars
increased to more than ______ times its previous level.
A) 2
B) 10
C) 50
D) 100

32.The real interest rate is equal to the:

A) amount of interest that a lender actually receives when making a loan.
B) nominal interest rate plus the inflation rate.
C) nominal interest rate minus the inflation rate.
D) nominal interest rate.

33.If the nominal interest rate is 1 percent and the inflation rate is 5 percent, the real interest
rate is:
A) 1 percent.
B) 6 percent.
C) 4 percent.
D) 5 percent.

34.If the real interest rate declines by 1 percent and the inflation rate increases by 2 percent,
the nominal interest rate must:
A) increase by 2 percent.
B) increase by 1 percent.
C) remain constant.
D) decrease by 1 percent.

35.If the real interest rate and real national income are constant, according to the quantity
theory and the Fisher effect, a 1 percent increase in money growth will lead to rises in:
A) inflation of 1 percent and the nominal interest rate of less than 1 percent.
B) inflation of 1 percent and the nominal interest rate of 1 percent.
C) inflation of 1 percent and the nominal interest rate of more than 1 percent.
D) both inflation and the nominal interest rate of less than 1 percent.

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 36.The one-to-one relation between the inflation rate and the nominal interest rate, the Fisher
effect, assumes that the:
A) money supply is constant.
B) velocity is constant.
C) inflation rate is constant.
D) real interest rate is constant.

37.According to the quantity theory a 5 percent increase in money growth increases inflation
by ___ percent. According to the Fisher equation a 5 percent increase in the rate of
inflation increases the nominal interest rate by _____.
A) 1; 5
B) 5; 1
C) 1; 1
D) 5; 5

38.According to the quantity theory and the Fisher equation, if the money growth increases
by 3 percent and the real interest rate equals 2 percent, then the nominal interest rate will
increase:
A) 2 percent.
B) 3 percent.
C) 5 percent.
D) 6 percent.

39.In the classical model, according to the quantity theory and the Fisher equation, an
increase in money growth increases:
A) output.
B) velocity
C) the nominal interest rate.
D) the real interest rate.

40.Evidence from the past 40 years in the United States supports the Fisher effect and shows
that when the inflation rate is high, the ______ interest rate tends to be ______.
A) nominal; high
B) nominal; low
C) real; high
D) real; low

41.The ex ante real interest rate is equal to the nominal interest rate:
A) minus the inflation rate.
B) plus the inflation rate.

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C) minus the expected inflation rate.
D) plus the expected inflation rate.

42.When a person purchases a 90-day Treasury bill, he or she cannot know the:
A) ex post real interest rate.
B) ex ante real interest rate.
C) nominal interest rate.
D) expected rate of inflation.

43.Equilibrium in the market for goods and services determines the ______ interest rate and
the expected rate of inflation determines the ______ interest rate.
A) ex ante real; ex ante nominal
B) ex post real; ex post nominal
C) ex ante nominal; ex post real
D) ex post nominal; ex post real

44.The ex ante real interest rate is based on _____ inflation, while the ex post real interest
rate is based on _____ inflation.
A) expected; actual
B) core; actual
C) actual; expected
D) expected; core

45.According to the Fisher effect, the nominal interest rate moves one-for-one with changes
in the:
A) inflation rate.
B) expected inflation rate.
C) ex ante real interest rate.
D) ex post real interest rate.

46.A positive relationship between nominal interest rates and inflation in the United States is
obvious in:
A) both recent data and nineteenth-century data.
B) recent data but not nineteenth-century data.
C) nineteenth-century data but not recent data.
D) neither nineteenth-century data nor recent data.

47.The ex post real interest rate will be greater than the ex ante real interest rate when the:
A) rate of inflation is increasing.
B) rate of inflation is decreasing.

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C) actual rate of inflation is greater than the expected rate of inflation.
D) actual rate of inflation is less than the expected rate of inflation.

48.In recent U.S. experience, inflation has:

A) been persistent from year to year, whereas in the nineteenth century inflation had
little persistence.
B) been persistent from year to year, and this was also true in the nineteenth century.
C) not been persistent from year to year, although it was persistent in the nineteenth
century.
D) not been persistent from year to year, and the same was true in the nineteenth
century.

49.The opportunity cost of holding money is the:

A) nominal interest rate.
B) real interest rate.
C) federal funds rate.
D) prevailing Treasury bill rate.

50.The real return on holding money is:

A) the real interest rate.
B) minus the real interest rate.
C) the inflation rate.
D) minus the inflation rate.

51.If the real return on government bonds is 3 percent and the expected rate of inflation is 4
percent, then the cost of holding money is ______ percent.
A) 1
B) 3
C) 4
D) 7

52.The general demand function for real balances depends on the level of income and the:
A) real interest rate.
B) nominal interest rate.
C) rate of inflation.
D) price level.

53.If the nominal interest increases, then:

A) the money supply increases.
B) the money supply decreases.

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C) the demand for money increases.
D) the demand for money decreases.

54.Consider the money demand function that takes the form (M/P)d = Y/4i, where M is the
quantity of money, P is the price level, Y is real output, and i is the nominal interest rate.
What is the average velocity of money in this economy?
A) i
B) 4i
C) 1/4i
D) 0.25

55.If the Fed announces that it will raise the money supply in the future but does not change
the money supply today,
A) both the nominal interest rate and the current price level will decrease.
B) the nominal interest rate will increase and the current price level will decrease.
C) the nominal interest rate will decrease and the current price level will increase.
D) both the nominal interest rate and the current price level will increase.

56.If the money supply is held constant, then an increase in the nominal interest rate will
______ the demand for money and ______ the price level.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease

57.If the demand for money depends on the nominal interest rate, then via the quantity
theory and the Fisher equation, the price level depends on:
A) only the current money supply.
B) only the expected future money supply.
C) both the current and expected future money supply.
D) neither the current nor the expected future money supply.

58.According to the classical theory of money, reducing inflation will not make workers
richer because firms will increase product prices ______ each year and give workers
______ raises.
A) more; larger
B) more; smaller
C) less; larger
D) less; smaller

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 59.According to the classical theory of money, inflation does not make workers poorer
because wages increase:
A) faster than the overall price level.
B) more slowly than the overall price level.
C) in proportion to the increase in the overall price level.
D) in real terms during periods of inflation.

60.Survey evidence indicates that economists worry ______ the general public does about
prices increasing more rapidly than their incomes.
A) more than
B) less than
C) about the same as
D) more intensely than

61.Which of the following is NOT an effect of expected inflation?

A) causes lower real wages.
B) leads to shoeleather costs.
C) increases menu costs.
D) leads to taxing of nominal capital gains that are not real.

62.The inconvenience associated with reducing money holdings to avoid the inflation tax is
called:
A) menu costs.
B) shoeleather costs.
C) variable yardstick costs.
D) fixed costs.

63.The costs of reprinting catalogs and price lists because of inflation are called:
A) menu costs.
B) shoeleather costs.
C) variable yardstick costs.
D) fixed costs.

64.Inflation ______ the variability of relative prices and ______ allocative efficiency.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases

65.Devoting resources to avoiding the costs of expected inflation leads to:

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A) eliminating the costs of expected inflation.
B) fewer relative price changes.
C) economic inefficiency.
D) a decrease in the transaction velocity of money.

66.Variable inflation hurts both debtors and creditors because:

A) inflation makes the money-fixed assets of creditors worth less.
B) inflation makes the money-fixed liabilities of debtors worth less.
C) most debtors and creditors are risk averse.
D) most debtors and creditors are risk neutral.

67.In the case of an unanticipated inflation:

A) creditors with an unindexed contract are hurt because they get less than they
expected in real terms.
B) creditors with an indexed contract gain because they get more than they contracted
for in nominal terms.
C) debtors with an unindexed contract do not gain because they pay exactly what they
contracted for in nominal terms.
D) debtors with an indexed contract are hurt because they pay more than they
contracted for in nominal terms.

68.The costs of unexpected inflation, but not of expected inflation, are:

A) menu costs.
B) the arbitrary redistribution of wealth between debtors and creditors.
C) unintended distortions of individual tax liabilities
D) the costs of relative price variability.

69.Between 1880 and 1896, the price level in the United States fell 23 percent. This
movement was ______ for bankers of the Northeast and ______ for farmers of the South
and West.
A) bad; bad
B) good; good
C) good; bad
D) bad; good

70.A variable rate of inflation is undesirable because:

A) debtors and creditors cannot protect themselves by indexing contracts.
B) shoeleather costs are greater under variable inflation than under constant inflation.
C) menu costs are greater under variable inflation than under constant inflation.
D) variable inflation leads to greater uncertainty and risk as compared to constant
inflation.

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 71.One possible benefit of moderate inflation is:
A) a reduction in boredom attributable to the changing prices.
B) the elimination of menu costs.
C) better functioning labor markets.
D) increased certainty about the future.

72.If inflation is 6 percent and a worker receives a 4 percent nominal wage increase, then the
worker's real wage:
A) increased 4 percent.
B) increased 2 percent.
C) decreased 2 percent.
D) decreased 6 percent.

73.If nominal wages cannot be cut, then the only way to reduce real wages is by:
A) adjustments via inflation.
B) unions.
C) legislation.
D) productivity increases.

74.A rate of inflation that exceeds 50 percent per month is typically referred to as a(n):
A) conflagration.
B) hyperinflation.
C) deflation.
D) disinflation.

75.Compared to periods of lower rates of inflation, during a hyperinflation all of the

following occur except:
A) shoeleather costs increase.
B) menu costs become larger.
C) relative prices do a better job of reflecting true scarcity.
D) tax distortions increase.

76.Hyperinflations ultimately are the result of excessive growth rates of the money supply;
the underlying motive for the excessive money growth rates is frequently a government's:
A) desire to increase prices throughout the economy.
B) need to generate revenue to pay for spending.
C) responsibility to increase nominal interest rates by increasing expected inflation.
D) inability to conduct open-market operations.

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 77.Which of the following would most likely be called a hyperinflation?
A) Price increases averaged 300 percent per year.
B) The inflation rate was 10 percent per year.
C) Real GDP grew at a rate of 12 percent over a year.
D) A stock market index rose by 1,000 points over a year.

78.In instances of hyperinflation, the delays involved in collecting taxes often result in:
A) decreased real government tax revenue.
B) large capital gains for creditors.
C) higher shoeleather costs of inflation.
D) higher ex ante real interest rates.

79.During hyperinflation real tax revenue of the government often drops substantially
because of the:
A) delay between when a tax is levied and when it is collected.
B) significantly greater menu costs of printing tax forms.
C) additional deductions taken for increased shoeleather costs.
D) greater uncertainty associated with extreme rates of inflation.

80.The major source of government revenue in most countries that are experiencing
hyperinflation is:
A) customs duties.
B) income taxes.
C) seigniorage.
D) borrowing.

81.In practice, in order to stop a hyperinflation, in addition to stopping monetary growth, the
government must:
A) lower taxes and raise government spending.
B) raise taxes and reduce government spending.
C) change from one kind of currency to another.
D) call for a new election.

82.To end a hyperinflation, a government trying to reduce its reliance on seigniorage would:
A) print more money.
B) raise taxes and cut spending.
C) lower taxes and increase spending.
D) lower interest rates.

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 83.Most hyperinflations end with _____ reforms that eliminate the need for _____.
A) monetary; taxes
B) monetary; currency
C) fiscal; seigniorage
D) fiscal; currency

84.The hyperinflation experienced by interwar Germany illustrates how fiscal policy can be
connected to monetary policy when government expenditures are financed by:
A) new taxes.
B) borrowing in the open market.
C) printing large quantities of money.
D) selling gold.

85.In Zimbabwe in the 1990s the government resorted to printing money to pay the salaries
of government employees because:
A) it was a means to avoid price controls.
B) of high rates of inflation.
C) of declining tax revenues.
D) of a need to stimulate the economy.

86.Which of the following is an example of a relative price?

A) the real interest rate
B) the capital stock
C) the dollar wage per hour
D) the price level

87.Variables expressed in terms of physical units or quantities are called ______ variables.
A) real
B) nominal
C) endogenous
D) exogenous

88.Variables expressed in terms of money are called ______ variables.

A) real
B) nominal
C) endogenous
D) exogenous

89.An example of a real variable is the:

A) dollar wage a person earns.

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B) quantity of goods produced in a year.
C) price level.
D) nominal interest rate.

90.An example of a nominal variable is the:

A) money supply.
B) quantity of goods produced in a year.
C) relative price of bread.
D) real wage.

91.The classical dichotomy:

A) cannot hold if money is neutral.
B) is said to hold when the values of real variables can be determined without any
reference to nominal variables or the existence of money.
C) fully describes the world in which we live, especially in the short run.
D) arises because money depends on the nominal interest rate.

92.According to the classical dichotomy, when the money supply decreases, _____ will
decrease.
A) real GDP
B) consumption spending
C) the price level
D) investment spending

93.The concept of monetary neutrality in the classical model means that an increase in the
money supply will increase:
A) real GDP.
B) real interest rates.
C) nominal interest rates.
D) both saving and investment by the same amount.

94.The characteristic of the classical model that the money supply does not affect real
variables is called:
A) the monetary basis.
B) monetary policy.
C) the quantity theory of money.
D) monetary neutrality

95.The theoretical separation of real and monetary variables is called:

A) the classical dichotomy.

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B) monetary neutrality.
C) the Fisher effect.
D) the quantity theory of money.

96.If the price level depends on both the current money supply and future expected money
supplies, in order to stop a hyperinflation, a central bank may try to establish credibility
by:
A) achieving increased political independence from the government.
B) increasing revenue from seigniorage.
C) encouraging increased government spending and tax cuts.
D) undertaking larger open-market purchases.

97.A small country might want to use the money of a large country rather than print its own
money if the small country:
A) is likely to be unstable, whereas the large country is likely to be stable.
B) is likely to be stable, whereas the large country is likely to be unstable.
C) needs the revenue for seigniorage.
D) wants to control its own inflation rate.

98.The phrase inflation is repudiation applies only if:

A) inflation is expected.
B) the government has no debt.
C) the government is a creditor.
D) the government is a debtor.

99.If consumption depends positively on the level of real balances, and real balances depend
negatively on the nominal interest rate in a neoclassical model, then:
A) the classical dichotomy still holds.
B) a rise in money growth leads to a fall in consumption and a rise in investment.
C) a rise in money growth leads to a rise in consumption and a fall in investment.
D) a rise in money growth leads to a rise in both consumption and investment.

100.If consumption depends positively on the level of real balances and real balances depend
negatively on the nominal interest rate in a neoclassical model, then the nominal interest
rate:
A) declines when the money growth rate rises.
B) is unchanged when the money growth rate rises.
C) rises 1 percent for each 1 percent rise in the money growth rate.
D) rises less than 1 percent for each 1 percent rise in the money growth rate.

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101.Assume that a series of inflation rates is 1 percent, 2 percent, and 4 percent, while
nominal interest rates in the same three periods are 5 percent, 5 percent, and 6 percent,
respectively.
a. What are the ex post real interest rates in the same three periods?
b. If the expected inflation rate in each period is the realized inflation rate in the previous
period, what are the ex ante real interest rates in periods two and three?
c. If someone lends in period two, based on the ex ante inflation expectation in part b, will he
or she be pleasantly or unpleasantly surprised in period 3 when the loan is repaid?

102.Mary Tsai is paid $3,000 every 30 days. Her salary is deposited directly in her bank. She
spends all her money at a constant rate over the 30 days and must pay cash. She can (1)
withdraw all of the money at once; (2) withdraw half at once and the rest after 15 days;
(3) withdraw one-third at once, one-third after 10 days, and one-third at 20 days; or (4)
make any number of evenly spaced withdrawals. Each withdrawal costs her $2 in terms
of time and inconvenience. For each day that Mary has a dollar in the bank, she gets .03
cents (.0003 per dollar) in interest. Thus, if she withdraws half of her money immediately
and half in 15 days, she has $1,500 in the bank for 15 days and earns $6.75 interest.
a. Create a table showing transaction costs, interest earned, and total net earnings (+) or cost ()
associated with one, two, three, or four withdrawals per month.
b. How many withdrawals per month lead to the largest net earnings? If Mary chooses this
number, what will be her average amount of cash on hand over the 30 days?

103.Assume that the demand for real money balance (M/P) is M/P = 0.6Y 100i, where Y is
national income and i is the nominal interest rate (in percent). The real interest rate r is
fixed at 3 percent by the investment and saving functions. The expected inflation rate
equals the rate of nominal money growth.
a. If Y is 1,000, M is 100, and the growth rate of nominal money is 1 percent, what must
P be?
b. If Y is 1,000, M is 100, and the growth rate of nominal money is 2 percent, what must
P be?

104.A classical economist wears a T-shirt printed with the slogan Fast Money Raises My
Interest! Use the quantity theory of money and the Fisher equation to explain the slogan.

105.In classical macroeconomic theory, the concept of monetary neutrality means that
changes in the money supply do not influence real variables. Explain why changes in
money growth affect the nominal interest rate, but not the real interest rate.

106.Econoland finances government expenditures with an inflation tax.

a. Explain who pays the tax and how it is paid.
b. What are costs of the tax, assuming the tax rate is expected?

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107.If the demand for money depends positively on real income and depends inversely on the
nominal interest rate, what will happen to the price level today, if the central bank
announces (and people believe) that it will decrease the money growth rate in the future,
but it does not change the money supply today?

108.Although inflation is always and everywhere a monetary phenomenon, explain why:

a. the start of a hyperinflation is typically related to the fiscal policy situation, and
b. the end of a hyperinflation is usually related to changes in fiscal policy.

109.Consider two countries, Hitech and Lotech. In Hitech new arrangements for making
payments, such as credit cards and ATMs, have been enthusiastically adopted by the
population, thereby reducing the proportion of income that is held as real money
balances. Over this period no such changes occurred in Lotech. If the rate of money
growth and the growth rate of real GDP were the same in Hitech and Lotech over this
period, then how would the rate of inflation differ between the two countries? Carefully
explain your answer.

110.Interest rates played a part in the 1984 U.S. presidential debates. Some politicians
claimed that interest rates rose over the 19811983 period, while others claimed rates
fell. Below is a table showing interest rates and annual inflation rates from 1981 to 1983.
Interest Rate Annual
Year (annual %) Inflation Rate
1981 14.03% 10.3%
1982 10.69% 6.2%
1983 8.63% 3.2%
Reconcile these conflicting claims.

111.The costs of expected inflation cause productive resources of an economy to be directed

away from their efficient allocation. Explain how each of the following costs of expected
inflation distort the allocation of productive resources:
a. shoeleather costs
b. menu costs
c. the inconvenience of a changing price level

112.The quantity equation of money can be re-written as the quantity theory of money when
we assume velocity of money (V) to be constant. Assume there are three possible
developments:

a. There is a rise in the number of shopping malls.

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 b. There is a rise in the number of banks operating.

c. There is a rise in the number of ATMs.

Which of the above can alter the money velocity, and how?

113.Assume a simple economy where only burgers are traded. In a year, 100 burgers are
traded at the rate of $5 per burger. Assume two scenarios:

a. The economy has $100 in the form of 20 pieces of $5 bills.

b. The economy has $100 in the form of 100 pieces of $1 bills.

Calculate the velocity of money for both situations.

114.For a country A, the GDP growth rate is 8 percent and inflation is 4 percent. If the
velocity of money remains constant, what is the change in real money balances?

115.You are presented with the following equation: (1 + r )= (1 + i )/(1 +). Expand the
expression to solve for i. What assumption is required for this expression to be equal to
the Fischer equation?

116.If one were to own government bonds or other forms of financial assets, they would earn
a real interest rate. Yet, the opportunity cost of holding money is equal to the nominal
interest rate. Explain why and how.

117.The money demand function can be written as L (i, Y). Given the Fisher equation, this
means that the money demand function of the population already takes into account
inflation (i = r + ). Why do you think people have a problem with inflation?

118.Suppose a government has a tax revenue shortfall. Will hyperinflation inevitably follow
unless the government cuts in its fiscal expenditures?

119.During inflation, does a rise in shoe leather cost signify change in velocity of money?

120.If there are no unexpected changes in money supply in an economy, can there still be
unexpected inflation in the economy?

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121.Under high historical inflation rates, can non-indexation of contracts be non-damaging
for either party?

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Answer Key

1.C
2.D
3.C
4.D
5.D
6.A
7.C
8.B
9.B
10.C
11.B
12.D
13.D
14.B
15.D
16.A
17.B
18.D
19.A
20.A
21.C
22.A
23.A
24.C
25.B
26.A
27.D
28.B
29.B
30.B
31.D
32.C
33.B
34.B
35.B
36.D
37.D
38.C
39.C
40.A
41.C
42.A
43.A
44.A

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45.B
46.B
47.D
48.A
49.A
50.D
51.D
52.B
53.D
54.B
55.D
56.C
57.C
58.D
59.C
60.B
61.A
62.B
63.A
64.B
65.C
66.C
67.A
68.B
69.C
70.D
71.C
72.C
73.A
74.B
75.C
76.B
77.A
78.A
79.A
80.C
81.B
82.B
83.C
84.C
85.C
86.A
87.A
88.B
89.B
90.A

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 91.B
92.C
93.C
94.D
95.A
96.A
97.A
98.D
99.B
100.D
101.a. 4 percent; 3 percent; 2 percent
b. 4 percent; 4 percent
c. He or she will be unpleasantly surprised.
102.a.
Number of Transaction Interest Net Earnings (+)
Withdrawals Costs Earned or Costs ()
1 $2 $ 0.00
2 4 6.75
3 6 9.00
4 8 10.125
b. Mary should choose to make three withdrawals per pay period.
103.a. i = 4 percent, P = 1/2
b. i = 5 percent, P = 1
104.According to the quantity theory, if velocity and real output are constant, then increases
in the rate of money growth increase the rate of inflation. Fast money increases inflation.
Based on the Fisher equation, the nominal interest rate equals the real interest rate plus
the rate of inflation. If the real interest rate is constant, the higher inflation (from the
faster money growth rate) raises the nominal interest rate.
105.According to the Fisher equation, the nominal interest rate equals the real interest rate
plus the expected rate of inflation. The expected rate of inflation depends on the rate of
money growth, so the nominal interest rate depends on the rate of money growth.
According to classical macroeconomic theory, the real interest rate adjusts to bring the
level of saving and investment (both real variables) into equilibrium without reference to
the rate of money growth.
106.a. Holders of money pay the inflation tax, since the purchasing power of their money holdings
declines as a result of inflation generated when the government prints more money.
b. The inflation tax rate is the rate of inflation. If the inflation (tax) rate is expected, then the
costs of expected inflation include shoeleather costs, menu costs, the costs of relative price
variability, tax distortions, and the inconvenience of making inflation corrections.
107.People will expect lower inflation in the future. The nominal interest rate will fall. Money
demand will increase. Since the central bank does not immediately decrease the money
supply, prices must fall to keep the newly increased money demand equal to the constant
money supply. Thus, current prices fall as a result of expected future decreases in money
growth rates.
108.a. Hyperinflations frequently begin when governments require additional revenue from
seigniorage because tax revenue and/or government borrowing is insufficient to cover
government spending. The additional seigniorage is obtained by printing money, which leads

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 b. Hyperinflations usually end when fiscal policy changes, including tax increases and
government spending cuts, are made to eliminate the need for seigniorage and stops the
excessive increase in money.
109.The rate of inflation would be higher in Hitech. According to the quantity theory, if the
rates of money growth and real GDP growth rates are the same, differences in rates of
inflation are related to differences in velocity. An increase in velocity leads to a higher
rate of inflation, holding other factors constant. In Hitech the reduction in the proportion
of income held as real balances (smaller k) is the equivalent of an increase in velocity
and, consequently, a higher rate of inflation in Hitech than in Lotech.
110.Using the Fisher effect, the nominal interest rate fell from 14 percent to 8.6 percent over
the period, but the ex post real interest rate rose from 3.73 percent to 5.43 percent.
111.a. Resources are used to go to the bank and in other activities to reduce cash holding, rather
than in producing goods and services.
b. Resources are used to update prices on menus, in catalogs, and on other price lists, rather
than in producing goods and service.
c. Resources are used to specify and compare the value of dollars at different t
112.A rise in ATMs can lead to people reducing their average money holding and thereby
reducing k of the money demand function. As V=1/k, this can alter velocity V.
113.Velocity of money does not depend on the currency denominations. It is a measure for
each unit of money and not the unit of the currency. In this example, the velocity of
money V = (PT) / M = (5(100)) / 100 = 5 in both cases.
114.Percent change in M + percent change in V = percent Change in P + percent change
in Y . Here, percent change in V=0. Percent change in M - percent change in P = percent
change in Y. Given that the GDP growth rate is 8 percent, the change in real money
balances is 8 percent as well.
115.On expansion, the equation reads i = r + +r . If both r and are substantially lowered,
their product is much lower, such that i= r + is a good enough approximation.
116.Holding financial assets would give us returns r. The money we hold earns ( r) as it
loses value due to inflation. The sum total opportunity cost is r ( r) = r + r = i, the
nominal interest rate, as per the Fisher equation.
117.There is a difference between expected inflation and actual inflation rate. In the money
demand function, i = r + E , E is the expected inflation rate. The real problem is
when actual inflation rates do not match expected inflation rates. Thus, variable inflation
is the main concern rather than inflation per se.
118.No. A government has the option of borrowing money just like any other economic entity.
It is only when a government is deemed as a poor borrower and lenders refuse to lend to
it that the government is forced to print money to cover its expenses, which might trigger
hyperinflation.
119.No. V = Y / (M/P). Only when Y and V are fixed does an increase in M lead to a
subsequent rise in P to balance the equation. Conversely, any rise in P is compensated by
an equivalent rise in M such that the velocity of money does not actually change.
120.Yes. If there are shocks in the real economy affecting the factors of production and
production function such that total output Y is affected (say, falls), for a given money
supply M and fixed velocity of money V, P will rise leading to unexpected inflation
levels.
121.Yes. The real damage in a case of non-indexed contracts is high variable inflation. Thus,

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even if expected inflation is high, as long as there is no high variable inflation, non-
indexed contracts may be party neutral.

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