Economics 11

Spring 2005

Due Friday April 15      Homework 9

 

 

Ch 17

 

Problems 1, 7, 11

 

1.  The money supply is $500 billion, nominal GDP is $10 trillion and real GDP is $5 trillion.

a.  the price level is 20, since PL x Real GDP = Nominal GDP  so $10 = $0.5 x 20.

b.  Start with MV = PY.  You are given that V and M are both constant.  If Y increases by 5%, then P must fall by 5%

c.  If the Fed wants to keep the price level stable and if V is stable, then the Fed should increase the money supply by 5% to keep the price level stable.

d.  If the Fed wants inflation to be 10%, it should increase the money supply by 15%.  MV will rise by 15%, Y rises by 5% and PL rises by 10%. 

 

7.  Bob grows beans and Rita grows rice.  They always consume equal amounts of rice and beans.  In 2000, beans cost $1 per pound and rice costs $3.

a.  In 2001 beans cost $2 and rice was $6.  Inflation is 100%.  Bob’s income has doubled since both Bob and Rita both eat the same amount.  Rita’s income has also doubled.   So incomes have doubled for both of them but so has their cost of eating (which is their only cost of living).  So neither has been made better or worse off.

b.  In 2001 beans cost $2 and rice costs $4.  The price of beans has doubled and the price of rise has gone up 33.3%.  The inflation rate is the economy is the quantity of each times their price in the second year divided by the quantity of each times their prices in the first year.

2001:  (Pb1 x B) + (Pr1 x R)    where Pb is the price of beans and Pr is the price of rice and B is the quantity of beans and R is the quantity of rice.

In 2000  it is :  (Pb00 x B) + (Pr00 x R)

In both years B and R do not change

So the inflation rate is     [(Pb1 x B) + (Pr1 x R)] / [(Pb00 x B) + (Pr00 x R)] = [(Pb1B) + (Pr1R)] / [(Pb00B) + (Pr00R)]=

[(Pb1) + (Pr1)] / [(Pb00) + (Pr00)] = ($2+$4)/($1+$3) = 6/4 = 1.50 = 50% inflation rate

 

Bob now gets two times as much as he used to for his beans and only pays 33.3% more for his rice.  Rita now pays 2 times as much for her beans and gets 33.3% more for her rice.  Bob is better off and Rita is worse off. 

 

c.  Now in 2001 beans cost $2 and rice costs $1.50.  The price index in the second year is the second year prices times the amount purchased.     ($2 + $1.50) divided by the initial year which is ($1 + $3).    3.50/4.00 = .875 so inflation is -12.5%. 

Bob is better off because he gets twice as much for his beans but his cost for rice has fallen in half.  Rita has to pay twice as much but only gets ˝ as much for her rice.  

 

d.  What matters more is the relative price of rice and beans, not the overall inflation rate. 

 

11.  People expect inflation to be 3% but in fact prices rise by 5%.

a.  Government revenues grow with inflation.  This helps the government because the real value of government debt is falling.  People buy government debt (bonds) because they get a certain interest rate, which in part is based on expected inflation.  When actual inflation is higher, the government (creditor) benefits and the borrower (a debtor) is worse off.

b.  A homeowner with a fixed rate mortgage benefits when actual inflation is higher than expected.  The fixed nominal rate means that the real interest rate is lower.

c.  A union worker in the second year of a contract is hurt because her wages go up by expected inflation plus a real amount but if actual inflation is higher, the real increase in wages will be lower.

d.  A college with an endowment that has some government bonds will be hurt.  See question a. The college gets a lower real interest rate.

 

 

 

 

 

Also, the last day of trading for the Stock Market Game is April 22.  Your papers are due April 29.  I expect one paper per group.  Be sure to have all group members’ names on the paper and your team ID numbers (not the passwords).  The requirements for the paper were given to you on the instruction sheet for the SMG, which you can find here.