Homework 7: Money & Inflation

1. The government of a country increases the growth rate of the money supply from 5
percent per year to 50 percent per year. What happens to prices? What happens to nominal
interest rates? Why might the government be doing this?
- Prices: With such a great increase in the growth rate of the money supply, there would be a
substantial increase in the supply of money in the economy. This excess money supply would lead
to a surge in aggregate demand, which, in turn, would put upward pressure on prices.
Consequently, inflation would occur, and prices would rise at a faster rate.

- Nominal Interest Rates: The impact on nominal interest rates can vary depending on how the
central bank responds to the increased money supply growth rate. If the central bank takes steps to
counteract the inflationary pressures resulting from the increased money supply, it may raise
interest rates to discourage excessive borrowing and spending. However, if the central bank does
not respond promptly or effectively, inflation expectations may rise, leading to higher nominal
interest rates as lenders demand compensation for the eroding value of money over time.

- Government's Motivation: There can be several reasons why a government might choose to
increase the growth rate of the money supply:

+ Stimulating Economic Growth: The government may aim to stimulate economic activity by
injecting more money into the economy. By increasing the money supply, they hope to boost
consumer spending, business investment, and overall economic growth. However, such a drastic
increase in the money supply growth rate could have unintended consequences and risks, including
high inflation and economic instability.

+ Addressing Deflationary Pressures: If the country is experiencing deflation, where prices are
falling and economic activity is sluggish, the government may increase the money supply to
counteract deflationary pressures and encourage spending and investment. However, a sudden and
significant increase in the money supply growth rate may lead to excessive inflation rather than
addressing deflation.

+ Financing Government Spending: Increasing the money supply can also be a way for the
government to finance its spending. By creating more money, the government can have additional
funds to cover budget deficits or fund public projects. However, this approach can have adverse
effects on the economy, such as inflation and a loss of confidence in the currency.
* It's important to note that while increasing the money supply can have short-term benefits, such
as stimulating economic activity, it also carries the risk of inflation and other long-term
consequences. Governments must carefully consider the potential trade-offs and implications of
such actions, as excessive money supply growth rates can lead to economic instability and erode
the value of the currency.
2. Suppose that changes in bank regulations expand the availability of credit cards so that
people need to hold less cash. a. How does this event affect the demand for money? b. If the
Fed does not respond to this event, what will happen to the price level? c. If the Fed wants to
keep the price level stable, what should it do?
a. The expansion of credit card availability, which reduces the need for cash, would likely decrease
the demand for money. Credit cards provide a convenient and widely accepted means of payment,
reducing the need for individuals to hold cash for everyday transactions. Thus, people may choose
to hold less physical currency and rely more on credit cards, electronic transfers, or other non-cash
payment methods. This decrease in the demand for money would primarily affect the transactional
demand for money, which is the demand for money to facilitate day-to-day transactions.
b. If the Federal Reserve (Fed) does not respond to the increased availability of credit cards and
the resulting decrease in the demand for money, it could lead to downward pressure on the price
level. When the demand for money decreases, there is an excess supply of money in the economy.
This excess money supply can cause a decrease in the value of money relative to goods and
services, resulting in inflationary pressures. However, it's important to note that the impact on the
price level would depend on other factors influencing the economy, such as aggregate demand and
supply conditions.

c. If the Fed wants to keep the price level stable in response to the decreased demand for money, it
can take several actions:

- Open Market Operations: The Fed can conduct open market operations by buying government
securities, such as Treasury bonds, from banks. This increases the money supply, offsetting the
decrease in the demand for money caused by the expansion of credit cards.

- Lowering Interest Rates: The Fed can lower interest rates to encourage borrowing and spending,
thereby stimulating aggregate demand. By reducing the cost of borrowing, individuals and
businesses may be incentivized to take out loans and invest, which can help offset the decrease in
the demand for money.

- Communication and Guidance: The Fed can communicate its commitment to maintaining price
stability and its intention to adjust monetary policy as needed to counteract any potential
inflationary or deflationary pressures resulting from changes in the demand for money. Clear
communication can help manage inflation expectations and provide guidance to market
participants.

- Reserve Requirements: The Fed can adjust reserve requirements, which are the amount of funds
that banks are required to hold in reserve against their deposits. By reducing reserve requirements,
the Fed can increase the lending capacity of banks, potentially offsetting the decrease in the
demand for money.
3. It is sometimes suggested that the Federal Reserve should try to achieve zero inflation. If
we assume that velocity is constant, does this zero-inflation goal require that the rate of
money growth equal zero? If yes, explain why. If no, explain what the rate of money growth
should equal.

If we assume that velocity is constant, achieving zero inflation does not necessarily require the rate
of money growth to be zero. The relationship between the rate of money growth, inflation, and
velocity can be explained using the equation of exchange:

M*V=P*Y

where M is the money supply, V is the velocity of money (the average number of times a unit of
currency is spent in a given period), P is the price level, and Y is real output or income.

Assuming velocity is constant, any change in the money supply (M) will have a proportional effect
on nominal GDP (P * Y). If the goal is to achieve zero inflation, it means that the percentage
change in the price level (P) should be zero.

To achieve zero inflation with constant velocity, the rate of money growth (percentage change in
M) should equal the rate of growth in real output or income (percentage change in Y). This is
known as the principle of monetary neutrality. When the rate of money growth matches the rate of
growth in real output, the increase in the M is absorbed by the expanding economy, and there is no
upward pressure on prices.
In this scenario, the rate of money growth should be equal to the growth rate of real output or
income. If the rate of money growth exceeds the rate of growth in real output, it can lead to
inflationary pressures. Conversely, if the rate of money growth is lower than the rate of growth in
real output, it can result in deflationary pressures.

4. Suppose that people expect inflation to equal 3 percent, but in fact, prices rise by 5
percent. Describe how this unexpectedly high inflation rate would help or hurt the
following:
a. the government
b. a homeowner with a fixed-rate mortgage
c. a union worker in the second year of a labor contract
d. a college that has invested some of its endowment in government bonds.
a. The government: Unexpectedly high inflation can have mixed effects on the government. On
one hand, if the government is a net debtor, meaning it owes more in nominal terms, the real value
of its debt decreases. This can be beneficial for the government as it effectively reduces the burden
of debt. However, if the government has fixed income streams, such as tax revenues or fixed
payments to individuals, the purchasing power of those incomes decreases with higher inflation,
which can strain the government's budget.
b. A homeowner with a fixed-rate mortgage: A homeowner with a fixed-rate mortgage would
benefit from unexpectedly high inflation. With inflation exceeding expectations, the real value of
the mortgage debt will decrease. The homeowner's income and home value may increase with
inflation, while the mortgage payment remains fixed. This results in a decrease in the real burden
of the mortgage, providing a financial advantage to the homeowner.
c. A union worker in the second year of a labor contract: A union worker in the second year of a
labor contract may be negatively affected by unexpectedly high inflation. Labor contracts often
include fixed wage increases, typically negotiated based on expected inflation rates. If actual
inflation exceeds expectations, the real wage increase may be lower than expected, causing a
decrease in purchasing power for the worker. This can result in a reduction in the standard of
living for the worker.
d. A college that has invested some of its endowment in government bonds: Unexpectedly high
inflation can hurt a college that has invested some of its endowment in government bonds.
Government bonds usually offer fixed interest rates. With higher inflation, the purchasing power
of the interest income generated by these bonds decreases. Thus, the college's real return on
investment may be lower than expected, potentially impacting its financial stability and ability to
meet its obligations.