6.1
LEARNING OBJECTIVE: Define money and discuss its four functions (pages x – x)
Review Questions
1.1 What is a store of value? What types of assets act as a store of value?
1.2 What is a medium of exchange? Why must money act as a medium of exchange?
1.3 What is a standard of deferred payment, and why is it important?
1.4 What is a unit of account, and why is it important?
1.5 What is the difference between commodity money and fiat money?
1.6 List the components of M1 and M2.
1.7 What is the difference between the money supply and the monetary base?
Problems and Applications
1.8 Each of the following has been used as money at some time in the past. Comment on how
well each fulfills the four functions of money and why it might be used for money.
a. Gold or silver.
b. Cigarettes.
c. Salt or peppercorns.
1.9 A famous commodity money example has to do with Yap, an island group in the Pacific,
which uses large stone disks known as Rai. These disks can be up to 12 feet in diameter and are
made of a stone that is not native to the islands, so they had to be transported by canoe with great
difficulty and risk. Thus the stones are valued both due to their scarcity and because of the
history of their acquisition.
a. How well do large stones fulfill the functions of money?
b. In 1874, a Western immigrant to the islands used ships to transport more stones to
Yap. While these stones were larger, they did not have the history of risk and hardship
associated with them.
i. What happened to Yap’s money supply and to the overall value of stones?
ii. How does this illustrate a central problem of commodity monies?
iii. How would you expect old stones to be valued relative to new stones, and
why?
1.10 A New York Times column, in the fall of 2009, reported that the value of the dollar was
falling, in part because:
“Investors who had sought shelter in the American currency's perceived stability were
beginning to funnel their money into hard assets like gold…. ”
What does the article mean by a “hard asset?” Why is the dollar not a hard asset?
[Source: The New York Times, “Times Topics: Dollar”, October 12, 2009.]
1.9 [Related to Making the Connection, p. x]
In March, 2010, the money supply, as measured by M1, was approximately $1,719 billion. The
monetary base was approximately $2,077.
a. What was the money multiplier?
b. Banks at this time were holding considerable amounts of excess reserves. If they
began to loan out those excess reserves, what would happen to the money multiplier?
To the monetary base? To the money stock?
[Source: Federal Reserve Bank of St. Louis]
1.10 Economist Gregory Mankiw explained in a newspaper column that
“…banks may start lending out some of their hoards of reserves….[leading to]… growth
in broader money-supply measures and… to substantial inflation. But the Fed has the
tools it needs to prevent that outcome.”
a. What tools does the Fed have to change the money supply?
b. How would the Fed use these tools to reduce the money supply?
[Source, N. Gregory Mankiw, “Bernanke and the Beast”, The New York Times, January 16,
2010]
1.11 Consider the following statement.
“As the central bank of the United States, only the Federal Reserve can print money.
Thus the Federal Reserve has complete control over the money supply.”
Do you agree with this statement? Explain.
6.2
LEARNING OBJECTIVE: Explain the quantity theory of money and use it to explain
inflation (pages x – x)
2.1 State the quantity equation.
2.2 What is the velocity of money?
2.3 Why must velocity be constant or predictable for the quantity equation to be useful?
2.4 Use the quantity theory to relate changes in the money supply to inflation.
Problems and Applications
2.5 [Related to Making the Connection, p, ]
In February 2010, the Fed announced an increase in the discount rate, the rate at which the Fed
makes loans to banks. How does increasing the discount rate correspond with the Fed’s desire to
begin to shrink the monetary base?
2.6 [Related to Solved Problem 6.1, p. ]
The average annual growth rate of potential real GDP for the United States is 3.1 percent.
Assume that the growth rate of velocity is 0%, and the growth rate of the money supply is 5%.
a. What is the current rate of inflation?
b. What will happen to the inflation rate if the rate of growth of the money supply
increases to 7%?
c. What will happen to the inflation rate if the rate of growth of the money supply
increases to 7%, and at the same time, the growth rate of velocity increases to 2%?
2.7 In March, 2010, the money supply, as measured by M1, was approximately $1,719 billion.
Nominal GDP was $14,256.3 billion.
a. What was the velocity of money?
b. For the same period, M2 was $8,503.6 billion. What is the velocity of money as
measured by M2?
c. Why are these measures different?
[Source: Federal Reserve Bank of St. Louis]
2.8 [Related to the Chapter Opener]
A Wall Street Journal article on the Fed’s options for reducing inflationary pressure states:
“In the old days, when the Fed wanted to tighten…. the task was easy. It pulled a few
billion dollars out of short-term lending markets by selling Treasury bonds…”
a. How does the Fed “pull” money out of the system?
b. The article further suggests that the Fed’s task may be more difficult this time
“[b]ecause the Fed has flooded the financial system with so much money…” Why
would the significant increase in the money supply make the Fed’s job harder?
[Source: Jon Hilsenrath, “As the Fed Uses Fewer Tools, Exit Plan Emerges”. Wall Street
Journal, December 15, 2009.]
2.9 Suppose that the growth rate of the economy increases, but the velocity of money remains
constant and the Fed does not change the growth rate of the money supply.
a. What would happen to the inflation rate?
b. Would this be a good thing for the economy? Explain your answer.
2.10 The quantity theory of money states that changes in the money supply have predictable
effects on nominal spending, or in other words, that money growth determines price growth in
the long run. Under what circumstances might this theory be incorrect? Explain.
6.3
LEARNING OBJECTIVE: Discuss the relationship between money growth, inflation, and
nominal interest rates (pages x – x)
3.1 Explain the difference between an ex post and an ex ante real interest rate.
3.2 Under what circumstances are the ex post and ex ante real interest rates the same?
3.3 What is the Fisher equation?
3.4 What is the Fisher effect?
3.5 Do the data support the Fisher effect?
3.6 How does an increase in the money supply affect the nominal interest rate?
Problems and Applications
3.7 [Related to Solved Problem 6.2, p. ]
The average growth rate of potential real GDP for the U.S. is 3.1%, and the ex ante real interest
rate on corporate Aaa bonds has averaged 2.8%.
a. If the growth rate of velocity is 0%, and the growth rate of the money supply is 6%,
what is the nominal interest rate?
b. What will happen to the nominal interest rate if the rate of growth of the money
supply falls to 3%?
c. What will happen to the nominal interest rate if the rate of growth of the money
supply falls to 3% and the average growth rate of potential real GDP falls to 2.5%?
3.8 Suppose that inflation has been equal to 3% per year for as long as anyone can remember
and that the real return that banks require on good-quality mortgage loans is 2%.
a. What nominal interest rate would banks currently be charging on typical mortgages?
b. Now the central bank unexpectedly increases the growth rate of the money supply by
1%, and this change is expected to be permanent. What nominal rate will banks
charge on new mortgages?
c. What is the ex post real return on mortgages made prior to the increase in money
supply growth?
3.9 In early May, 2010, the interest rate on one year Treasury notes was 0.372%. The interest
rate on ten year Treasury notes was 3.42%. Assuming that the level of risk on these two
notes is the same, what does this imply about expectations about inflation?
3.10 In the spring of 2010, as worries about the possibility of the Greek government defaulting
on its sovereign debt rose, the nominal interest rate on Greek bonds increased sharply.
a. Why did the nominal interest rate increase?
b. Would you expect there to be a difference between ex post and ex ante interest rates in
this situation?
3.11 During the Great Depression, the price level actually fell in some years.
a. With a falling price level, what happens to the ex post real interest rate?
b. In contrast, during the 2007-2009 financial crisis, nominal interest rates on Treasury
bills were close to zero, and inflation remained positive. What happened to the e
post real interest rate on Treasury bills?
c. Why would savers be willing to hold Treasury bills with a negative real return?
6.4
LEARNING OBJECTIVE: Explain the costs of inflation (pages x – x)
4.1 What is seigniorage, and how is it an “inflation tax?”
4.2 What are shoe leather costs?
4.3 What are menu costs?
4.4 What are the costs of unexpected inflation?
4.5 How can the expected inflation rate be determined?
4.6 How does inflation uncertainty affect the allocation of resources?
4.7 Are there any benefits to inflation?
Problems and Applications
4.8 [Related to Making the Connection, p. ]
Some central banks set an explicit inflation target, essentially committing themselves to
attempting to keep inflation within a certain range. How is this likely to affect inflationary
expectations?
4.9 40 years ago, it was typical for grocery stores to post prices by labeling each can or box
individually. Thus when prices changed, a stock person would have to relabel every item in the
store so that the cashier could ring them up correctly. Today, most prices are posts on shelf
labels and scanned into cash registers using bar codes.
a. How has this affected menu costs?
b. Are menu costs different for all grocery store items? Explain.
4.10 Suppose that consumer preferences are changing, so that more consumers wish to buy chicken and
fish and fewer wish to buy other meats, such as beef and pork.
a. If inflation is low and fully anticipated, how would you expect the relative price of these goods
to change, and how would that affect production of these goods?
b. Suppose now that inflation is volatile, so that it is difficult to tell the difference between an
increase in the price of an individual good versus an increase in the overall price level. How
might this lead to a misallocation of resources?
4.11 It is often said that inflation “greases the wheels of the labor market.” Explain what this
statement means.
4.12 The inflation rate in a economy has been 4% for a considerable period of time. The central
bank unexpectedly increases the rate of growth of the money supply by 2%. Describe the effect
on each of the following.
a. The inflation rate.
b. Lenders.
c. Borrowers.
d. People with fixed incomes.
4.13 In the United States, in 2010, some of the tax brackets for a single person are as follows:
Income range
Tax percentage
$0-$8,375
10%
$8,375-$34,000
15%
$34,000-$82,400
25%
Thus, for example, you pay 10% on the first $8,375 of income and 15% on the income between
$8,375 and $34,000.
a. If Stefanie is currently earning $33,500 per year, how much does she pay in taxes?
b. Suppose that this year, inflation is 8%, and Stefanie’s nominal wages rise by 5%.
What has happened to Stefanie’s nominal income? To her real income?
c. What has happened to Stefanie’s tax payment? Has her real tax payment increased,
stayed the same, or decreased?
4.14 The idea of “shoe leather costs” is that people wear out their shoes going back and forth to
the bank. While this is unlikely in reality, what are some examples of actual costs that you might
incur hedging against inflation?
6.5
LEARNING OBJECTIVE: Explain the causes of hyperinflation (pages x – x)
5.1 What is hyperinflation?
5.2 How does hyperinflation occur?
5.3 How can hyperinflation be stopped?
Problems and Applications
5.4 While hyperinflations are always caused by rapid growth in the money supply, they can be
intensified by the actions of economic agents trying to protect themselves from inflation by
spending money as soon as they receive it.
a. What is likely to happen to the velocity of money during a hyperinflation?
b. Use the quantity equation to show how the change in velocity affects the inflation rate.
5.5 By early 2009, Zimbabwe was experiencing inflation that was estimated to be 231 million
percent per year. Because of the rapidly falling value of the currency, the government was
forced to issue currency in larger and larger denominations, including a $50 billion note. At the
time, a $50 billion note would purchase about two loaves of bread. An economist in Zimbabwe
was quoted as saying:
"It is a waste of resources to print Zimbabwe dollar notes now. Who accepts a currency
that loses value by almost 100 percent daily?"
a. Why would printing notes be a waste of resources?
b. The government authorized many stores to make transactions in foreign currencies.
Why would this be necessary?
[Source: “Zimbabwe Introduces $50 Billion Note”, CNN.com, January 10, 2009.]
5.6 Since hyperinflations are caused by governments printing money, why don’t the
governments of these countries simply choose to reduce the rate of the growth of the money
supply? Carefully explain the consequences of these actions.
5.7 One problem of hyperinflation is that it reduces economic growth, both through resource
misallocation and by reducing savings and investment.
a. Why does hyperinflation cause misallocation of resources?
b. Why does hyperinflation reduce savings and investment?
c. What impact do these things have on economic growth?
5.8 Hyperinflation occurred in the South during the U.S. Civil War (1861-1865). Unable to tax
effectively in a largely agricultural economy, the Confederate government was forced to print
money, eventually creating a money supply of approximately $1.5 billion (Confederate dollars).
a. Explain how the rapid increase in the money supply combined with wartime scarcity
of goods would cause prices to escalate.
b. In 1864, the Confederate government attempted to reduce inflation by reducing the
money supply by approximately 1/3 by forcing bills to be converted into bonds by a set
date (or converted at a penalty after that date). What do you expect that the immediate
effect of this announcement would be?
DATA PROBLEMS
D1: The Federal Reserve Bank of St. Louis offers data on monetary aggregates at its website
(http://research.stlouisfed.org/fred2/). Look at the data from 1995 to the present.
a. What is the relationship between M1 and M2? Which is more volatile?
b. The monetary base is called M0. Look at the data for M0, and compare it with the
M1 and M2 measures you found above.
i.
In general, what happens to M1 and M2 as the monetary base increases?
ii.
Is this relationship different in the 2007-2009 period?
D2: Steve Hanke at the Cato Institute (http://www.cato.org/zimbabwe) has calculated a
hyperinflation index for Zimbabwe and other famous hyperinflations.
a. Where does Zimbabwe rank? How long did it take for prices to double at the peak of
the hyperinflation?
b. Search media sources to find out what the current state of Zimbabwe’s economy is.
How did this occur?
D3: The World Bank (www.worldbank.org) has data on money growth rates for different
countries. This measure is listed as “Money and Quasi-Money” growth, and is roughly
the same as M2.
a. What countries have the most rapid rates of money growth? The slowest?
b. Is there a relationship between the growth rate of the money supply and level of
development?
c. Compare this data with the growth rate of consumer prices. Does this seem to
confirm or refute the quantity theory?
D4: [Related to Macro Data, p. x]
As discussed in the chapter, one way of measuring inflationary expectations is by looking at the
difference between the interest rate on a Treasury bond and TIPS Treasury bond of the
same maturity. Return to the St. Louis Fed site, and find the current rate of expected
inflation for 10 year bonds. What is the real interest rate?
D5: [Excel question] Use the world data that you found in Data Problem D3.
a. Find the correlation coefficient for M2 and consumer price growth for a group of ten
industrialized countries.
b. Find the correlation for a group of ten developing countries.
c. Now find the correlation coefficient for the entire group.
d. If you have had a statistics class covering regression analysis, use money growth as
the dependent variable and price growth as the independent variable. Explain your
results.