382 PART VI MONEY AND PRICES IN THE LONG RUN PROBLEMS AND APPLICATIONS Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion. a. What is the price level? \Atrhat is the velocity of money? b. Suppose that velocity is constant and the economy's output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant? c. What money supply should the Fed set next year if it wants to keep the price level stable? d. ltVhat money supply should the Fed set next year if it wants inflation of 10 percent? 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? 7. 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? 3. It is often suggested that the Federal Reserve 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. 4. Suppose that a country's inflation rate increases sharply. What happens to the inflation tax on the holders of money? Why is wealth that is held in savings accounts nof subject to a change in the inflation tax? Can you think of any way holders of savings accounts are hurt by the increase in the inflation rate? 5. Hyperinflations are extremely rare in countries whose central banks are independent of the rest of the government. Why might this be so? 6. Let's consider the effects of inflation in an economy composed of only two people: Bob, a bean farmer, and Rita, a rice farmer. Bob and Rita both always consume equal amounts of rice and beans. In 2008, the price of beans was $1, and the price of rice was $3. a. Suppose that in 2009 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 2009 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 2009 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? If the tax rate is 40 percent, compute the before- tax real interest rate and the after-tax real inter- est 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. What are your shoeleather costs of going to the bank? How might you measure these costs in dollars? How do you think the shoeleather costs of your college president differ from your own? Recall that money serves three functions in the economy. What are those functions? How does inflation affect the ability of money to serve each of these functions? 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 endow- ment in government bonds 1. 2. 9. 10.
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