Tutorial 8

Group:
Nghiem Truong Giang - 2Q18 - 1806080041
An Duc Hoang - 2Q18 - 1806080059

II- Short Answer questions

1. Nominal variables are those measured in monetary units, while real variables are those
measured in physical units. Examples of nominal variables include the prices of goods,
wages, and nominal GDP.
Examples of real variables include relative prices (the price of one good in terms of
another), real wages, and real GDP.
According to the principle of monetary neutrality, only nominal variables are affected by
changes in the quantity of money.
2. According to the Fisher effect, an increase in the inflation rate raises the nominal interest
rate by the same amount that the inflation rate increases, with no effect on the real
interest rate.
3. If inflation is less than expected, creditors benefit and debtors lose.
Creditors receive dollar payments from debtors that have a higher real value than was
expected.

III- Practise problem

1. a. Price Level= 200 (This is GDP deflator Nominal / real x 100) Velocity= 200 x 5 / 500
=2

b. Remember MxV=PxY
M=Money Supply
V=Velocity
P=GDP Deflator
Y=Real GDP
Is Y increase P must fall

c. To keep the price level stable, the Fed must increase the money supply by 5%,
matching the increase in real GDP. Then, because velocity is unchanged, the price level
will be stable.

d.If the Fed wants inflation to be 10%, it will need to increase the money supply 15%.
Thus M × V will rise 15%, causing P × Y to rise 15%, with a 10% increase in prices and
a 5% rise in real GDP.
2. a. People hold less money so the demand shifts left. Less money demanded at that price
level.

b. If the Fed does not respond, the value of money will decrease. Value of money is 1/P,
so the price level will increase.

c. The fed should decrease the money supply.

3. Hyperinflation is usually caused by governments printing money to try and stimulate
their economy and make it grow. If the central bank is independent, the central bank
controls how much money is printed (ie they control the money supply), so governments
can only spend by either raising taxes (which they are more reluctant to do because they
will get voted out of office), or by borrowing (but if they borrow and spend too much,
lenders will stop lending to them).
Independent central banks usually have a clearly defined objective of controlling inflation
and therefore won't just print more money for the government.
4. I assumed that nominal rates of interest were taxed.
a) Real interest rate before tax = 10 -5 =5
Nominal interest rate after tax = 10 *(1-0.40) = 6
Real interest rate after tax = 6 -5 =1
b) Real interest rate before tax = 6 - 2 = 4
Nominal interest rate after tax = 6 *(1-0.40) = 3.6
Real interest rate after tax = 3.6 - 2 = 1.6
c) Real interest rate before tax = 4 -1 =3
Nominal interest rate after tax = 4 * (1-0.40) = 2.4
Real interest rate after tax = 2.4 -1 = 1.4
5. a. The government will likely gain in terms of the tax treatment of income, which does
not recognize the effect of inflation on taxable income such as capital gains.

b. The homeowner with a fixed-rate mortgage will benefit. Inflation will reduce the value
of the currency in the future, so the homeowner will be paying back the mortgage
company with cheaper dollars.

c. A union worker would be probably be neutral, assuming that the worker's labor
contract contained a provision for a wage adjustment based on the change in the CPI. If
the adjustment lags the actual increase in the rate of inflation (thus, devaluing the
worker's wages), then there is a potential for the worker to be harmed to the extent his/her
wage is not adjusted in a timely manner.

d. The college would be harmed. The college expected that the yield rate it received (and
the price it paid for the bonds) would have been based on a 3% expected rate or inflation.
 However, the nominal market interest rate has now increased to 5%, and the value of the
bonds will have fallen (bond yields and interest rates are inversely related).

IV- Multiple choice questions

1c
2b
3d
4a
5b
6b
7c
8d
9b
10a
11c
12b
13a
14a
15b
16d
17b
18a
19b
20a