Econ 302: Intermediate Macroeconomic Theory
Discussion Handout - Week 7∗
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Inflation
• Inflation rate is the percentage change in price level.
πt =
Pt+1 − Pt
Pt
• The Cost of Inflation: High inflation can be very costly to the economy. Inflation generally
transfer resources from lenders to borrowers, because borrowers can repay their loans with
dollars that are worth less.
1. Suppose the consumer price index in the future takes the following values: P2020 = 110,
P2021 = 113. Viewing these price levels as prevailing at the end of each year, calculate the
inflation rate for the year 2021.
2. Suppose A lends 100 dollars to B. Inflation rate now increases from 1% to 2%. Who benefits
from the higher inflation rate?
3. Suppose that you put $100 in the bank today. Now, the annual nominal interest rate is 10%
and the inflation rate is 5%. You have to pay tax on interest income, and assume that you
are in the 30% income tax bracket.
(a) Compute the real return on your investment.
(b) Now, suppose that the annual nominal interest rate is 20% and the inflation rate is 15%.
Compute the real return on your investment.
∗
TA: Julio Mereb (mereb@wisc.edu) and Wentao Zhou (wzhou92@wisc.edu)
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The Quantity Theory of Money
• The Quantity Equation: Mt Vt = Pt Yt . Nominal GDP is equal to the effective amount of
money used in purchases.
– Mt : Amount of money in circulation (money supply).
– Vt : Velocity of money (the average number of times per year that each piece of paper
currency is used in a transaction).
– Pt : Price level.
– Yt : Real GDP.
4. Let’s consider the fiscal causes of high inflation. The government’s budget constraint is given
by G = T + ∆B + ∆M . G is government expenditure. T is total tax revenue. ∆B is the
net issuance of bonds (i.e., new bonds issued minus redemptions of old bonds). ∆M is the
change in the money supply.
Suppose in some year the country gets involved in a war and military expenses skyrockets.
The government spending is 20% of nominal GDP, the tax revenue is 4% of nominal GDP,
and the net issuance of bonds is equal to 1% of nominal GDP. Further assume the velocity
of money is constant and the money supply equals nominal GDP (M = YN ).
(a) Explain in words why a large government budget deficit could lead to high inflation.
(b) Using the numbers given, calculate the inflation rate when there is no real GDP growth.
(c) If real GDP grows at a rate of 10%, what is the inflation rate?
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