Practice Quizzes – Money Growth and Inflation

Topic 8: MONEY GROWTH AND INFLATION

I. TERMS AND DEFINITIONS : Choose a definition for each key term

1. Inflation

2. Deflation

3. Hyperinflation

4. Quantity theory of money

5. Velocity of money

6. Inflation tax

7. Fisher effect

8. Classical dichotomy

9. Monetary neutrality

10. Shoeleather costs

a. Economic loss suffered by consumers as the result of the lower purchasing power of their money because
printing money causes inflation
b. An economic theory which proposes a positive relationship between changes in the money supply and the
long-term price level of goods and services.
c. The one-to-one adjustment of nominal interest rate to inflation
d. An increase in the overall level of prices
e. Extraordinarily high inflation
f. Rate at which money circulates, changes hands, or turns over in an economy in a given period
g. A decrease in the overall level of prices

h. The resources wasted when inflation encourages people to reduce their money holdings

i. The theoretical separation of nominal and real variables

j. The proposition that changes in the money supply do not affect real variables

II. TRUE OR FALSE? EXPLAIN YOUR CHOICE BRIEFLY

1. If the Fed increases the money supply, the equilibrium value of money decreases and the
equilibrium price level must increase.
2. When the value of money is on the vertical axis, the money supply curve slopes upward
because an increase in the value of money induces banks to create more money.

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 Practice Quizzes – Money Growth and Inflation

3. In the long run, an increase in the growth rate of the money supply leads to an increase in
the real interest rate, but no change in the nominal interest rate.
4. When inflation turns out to be higher than expected, lenders can realize losses, while
borrowers can gain.
5. If the money supply is $500, real output is $250 units, and the average price of a unit of real
output is $2, the velocity if money is 10.

III. PROBLEM SOLVING

1. Let’s consider the effects of inflation in an economy composed only of two people: Bob, a bean farmer,
and Rita, a rice farmer. Bob and Rita both always consume equal amounts of rice and beans. In 2012,
the price of beans was $1, and the price of rice was $3.

a. Suppose that in 2013 the price of beans was $2 and the price of rice was $6. What was
inflation? Was Bob better off, worse off, or unaffected by the changes in prices? What
about Rita?
b. Now suppose that in 2013 the price of beans was $2 and the price of rice was $4. What was
inflation? Was Bob better off, worse off, or unaffected by the changes in prices? What
about Rita?
c. Finally, suppose that in 2013 the price of beans was $2 and the price of rice was $1.50.
What was inflation? Was Bob better off, worse off, or unaffected by the changes in prices?
What about Rita?
d. What matters more to Bob and Rita—the overall inflation rate or the relative price of rice
and beans?

2. If the tax rate is 40 percent, compute the before-tax real interest rate and the after-tax real interest rate in
each of the following cases.
a. The nominal interest rate is 10 percent, and the inflation rate is 5 percent.
b. The nominal interest rate is 6 percent, and the inflation rate is 2 percent.
c. The nominal interest rate is 4 percent, and the inflation rate is 1 percent.

IV. MULTIPLE-CHOICE QUESTIONS

1. The classical theory of inflation

a. is also known as the quantity theory of money.
b. was developed by some of the earliest economic thinkers.
c. is used by most modern economists to explain the long-run determinants of the inflation rate.
d. All of the above are correct.
2. Interest rates adjusted for the effects of inflation are
a. nominal variables
b. real variables.
c. classical variables.
d. dichotomous variables.

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 Practice Quizzes – Money Growth and Inflation

3. According to the classical dichotomy, which of the following is influenced by monetary factors?
a. real GDP
b. unemployment
c. nominal interest rates
d. All of the above are correct.
4. The principle of monetary neutrality implies that an increase in the money supply will
a. increase real GDP and the price level.
b. increase real GDP, but not the price level.
c. increase the price level, but not real GDP.
d. increase neither the price level nor real GDP.
5. The velocity of money is
a. the rate at which the central bank puts money into the economy.
b. the same thing as the long-term growth rate of the money supply.
c. the money supply divided by nominal GDP.
d. the average number of times per year a money unit is spent.
6. Assuming that V is constant, the quantity equation implies that an increase in M could result in
a. an increase in the price level.
b. an increase in real GDP.
c. an increase in nominal GDP.
d. a and c.
7. The inflation tax
a. transfers wealth from the government to households.
b. is the increase in income taxes due to lack of indexation.
c. is a tax on everyone who holds money.
d. All of the above are correct.

8. When deciding how much to save, people care most about

a. after-tax nominal interest rates.
b. after-tax real interest rates.
c. before-tax real interest rates.
d. before-tax nominal interest rates.
9. Which of the following inflation costs matter even if actual inflation and expected inflation
are the same?
a. menu costs
b. inflation tax
c. shoeleather costs
d. All of the above are correct.

10. Wealth is distributed from debtors to creditors when inflation is

a. high, but expected.
b. low, but expected.
c. unexpectedly high.
d. unexpectedly low.

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