Chapter 5 Mishkin (5)

Macreconomics: Policy and Practice (Mishkin) Chapter 5 Money and Inflation 5.1 What is Money? 1) Money is not ________. A) income because the former is a stock measure and the latter a flow B) wealth because the latter is generally used to procure the former C) as desirable as barter because the latter is more efficient than the former D) all of the above E) none of the above Answer: A Topic: 5.1 What is Money? AACSB: Reflective Thinking 2) Money is not ________. A) income because the former is a stock measure and the latter a flow B) wealth because the former is generally used to procure the latter C) as inefficient as barter because the latter requires a double coincidence of wants D) all of the above E) none of the above Answer: D Topic: 5.1 What is Money? AACSB: Reflective Thinking 3) Money is another measure of ________. A) income because they both are flow measures B) wealth because they both measure the total collection of property that serves as store of value C) the flow of earnings one draws every two weeks D) all of the above E) none of the above Answer: E Topic: 5.1 What is Money? AACSB: Reflective Thinking 4) Money serves as ________. A) a unit of account, B) a store of value C) a medium of exchange D) all of the above E) none of the above Answer: D Topic: 5.1 What is Money?

1 Copyright © 2012 Pearson Education, Inc.

5) Wealth ________. A) may serve the monetary function of store of value B) means essentially the same as money C) differs from money in that wealth is more liquid D) is the flow that corresponds to the stock of income E) none of the above Answer: A Topic: 5.1 What is Money? 6) Someone who has just inherited a "goldmine" has received a great deal of ________. A) wealth B) money C) income D) currency E) liquidity Answer: A Topic: 5.1 What is Money? 7) Fred has always been known as "the rich kid." Strictly speaking, this must mean that ________. A) Fred has a lot of cash B) Fred's income is quite high C) Fred won the lottery before he was legally eligible D) Fred has a flashy wardrobe E) Fred has a lot of wealth Answer: E Topic: 5.1 What is Money? 8) The phrase "double coincidence of wants" ________. A) is useful to explain why barter is an efficient practice B) refers to two people who have similar tastes C) suggests a quite improbable circumstance D) clarifies the distinction between income and wealth E) none of the above Answer: C Topic: 5.1 What is Money? AACSB: Reflective Thinking 9) The most liquid asset is ________. A) stocks B) bonds C) cash D) real estate E) none of the above Answer: C Topic: 5.1 What is Money? 2 Copyright © 2012 Pearson Education, Inc.

10) Subject to a few legal and practical restrictions, anything may be exchanged for anything else. The distinctive advantage of money is that ________. A) it is likely to retain its value, whether it is kept or exchanged B) it has little, if any, use other than exchange C) it can generate income while it is kept D) it is likely to be accepted by everyone in exchange for anything E) none of the above Answer: D Topic: 5.1 What is Money? AACSB: Reflective Thinking 11) Which of the following is most like money? A) game arcade tokens B) board game "money" C) credit cards D) baseball trading cards E) frequent flyer miles Answer: A Topic: 5.1 What is Money? AACSB: Reflective Thinking 12) A prisoner of war camp seems a likely place for "cigarette money," because ________. A) nearly all prisoners smoke cigarettes B) of the absence of better alternatives C) cigarettes are abundant and easy to count D) the guards can enforce the practice of accepting cigarettes as a medium of exchange E) cigarettes retain their value over time Answer: B Topic: 5.1 What is Money? AACSB: Reflective Thinking 13) Characteristics that enable an item to serve well as money include each of the following, except ________. A) durable B) abundant C) divisible D) portable E) verifiable Answer: B Topic: 5.1 What is Money? AACSB: Reflective Thinking

3 Copyright © 2012 Pearson Education, Inc.

14) Suppose you have a collection of gold coins from the 19th century. Comment on their suitability to provide for you each of the three functions of money. Answer: The coins are an exceptional store of value. They would serve well as a medium of exchange, eagerly accepted by most people. They are a poor unit of account, since their value fluctuates a great deal relative to other goods. The face value of the coins is not a reliable indicator of their worth relative to other goods. This is because they are valued primarily as a store of value (and historical/artistic artifacts), rather than as a medium of exchange. Topic: 5.1 What is Money? AACSB: Reflective Thinking 5.2 The Federal Reserve System and the Control of the Money Supply 1) In modern economies, the supply of money depends mainly on the economy's ________. A) tax rates B) mining of precious metals C) net exports D) growth of output of goods and services E) none of the above Answer: E Topic: 5.2 The Federal Reserve System and the Control of the Money Supply 2) In addition to the chairman of the Board of Governors, the FOMC consists of ________. A) Six rotating members of the Board of Governors and five presidents of Federal Reserve banks B) Six other members of the Board of Governors, four rotating bank presidents and the president of the New York Federal Reserve C) Six other members of the Board of Governors and five presidents of Federal Reserve banks; all twelve rotating members D) Twelve Federal Reserve Bank presidents E) none of the above Answer: B Topic: 5.2 The Federal Reserve System and the Control of the Money Supply 3) The Federal Reserve System consists of ________. A) eleven district banks and a board of governors B) ten district banks and the FOMC C) eleven district banks D) twelve district banks and a board of governors E) none of the above Answer: D Topic: 5.2 The Federal Reserve System and the Control of the Money Supply

4 Copyright © 2012 Pearson Education, Inc.

4) The FOMC ________. A) meets four times a year to decide on how to conduct open market operations that influence the money supply B) meets six times a year to decide on how to conduct open market operations that influence the money supply and interest rates C) meets eight times a year to decide on how to conduct open market operations that influence the money supply and interest rates D) meets twelve times a year to decide on how to conduct open market operations that influence interest rates E) none of the above Answer: C Topic: 5.2 The Federal Reserve System and the Control of the Money Supply 5) Open Market operations consist mainly of ________. A) the government buying and selling private securities in the open market B) the Fed buying and selling government securities in the open market C) the government selling its own securities in the open market D) the Fed setting rates for securities traded in the open market E) none of the above Answer: B Topic: 5.2 The Federal Reserve System and the Control of the Money Supply 6) When the Fed sells government securities in the open market, the money supply ________ because ________. A) decreases; banks lose liquidity, they make fewer loans and checking account deposits decrease B) increases; banks gain liquidity, they make more loans and checking account deposits increase C) increases; banks lose liquidity, they make more loans and checking account deposits increase D) decreases; banks gain liquidity, they make fewer loans and checking account deposits decrease E) none of the above Answer: A Topic: 5.2 The Federal Reserve System and the Control of the Money Supply AACSB: Reflective Thinking 7) When the Fed buys government securities in the open market, the money supply ________ because ________. A) decreases; banks lose liquidity, they make fewer loans and checking account deposits decrease B) increases; banks gain liquidity, they make more loans and checking account deposits increase C) increases; banks lose liquidity, they make more loans and checking account deposits increase D) decreases; banks gain liquidity, they make fewer loans and checking account deposits decrease E) none of the above Answer: B Topic: 5.2 The Federal Reserve System and the Control of the Money Supply AACSB: Reflective Thinking 5 Copyright © 2012 Pearson Education, Inc.

8) Open market operations alter the money supply by ________. A) influencing banks' ability to make loans to individuals and corporations B) adding currency to or withdrawing currency from banks' vaults C) adding currency to or withdrawing currency from the checking accounts of individuals and corporations D) influencing banks' ability to make loans to the government E) none of the above Answer: A Topic: 5.2 The Federal Reserve System and the Control of the Money Supply 9) Which of the following is true for the European Central Bank (ECB)? A) its executive board meets more often than the FOMC B) each member country's central bank has similar functions to the Federal Reserve Banks C) it is housed in Frankfurt, Germany D) all of the above E) none of the above Answer: D Topic: 5.2 The Federal Reserve System and the Control of the Money Supply AACSB: Reflective Thinking 10) Which of the following is true for the European Central Bank (ECB)? A) its executive board meets less often than the FOMC B) the members of its executive board have lifetime appointments C) it is a more decentralized system than the Federal Reserve D) all of the above E) none of the above Answer: C Topic: 5.2 The Federal Reserve System and the Control of the Money Supply AACSB: Reflective Thinking 11) Current Federal Reserve policy focuses on interest rates, rather than on monetary aggregates, because ________. A) monetary aggregates do not provide clear or consistent signals to guide policymakers B) open market operations affect interest rates more directly than they affect monetary aggregates C) according to the Fisher effect, the interest rate is a key determinant of the inflation rate D) all of the above E) none of the above Answer: A Topic: 5.2 The Federal Reserve System and the Control of the Money Supply

6 Copyright © 2012 Pearson Education, Inc.

12) Both the Federal Reserve System in the United States and the European Central Bank are comprised of geographically dispersed Banks. How might such decentralization contribute to successful monetary policy? Answer: The economies of both the U.S. and Europe encompass many regions with distinct economic specializations, income levels, demographics, etc. Policymakers need to be aware of this heterogeneity and of how the policies under consideration might impact some regions differently than others. Having had a role in the design and selection of policies, officials and citizens at the regional level will be more willing and able to support and to implement the policies. Topic: 5.2 The Federal Reserve System and the Control of the Money Supply AACSB: Reflective Thinking 5.3 Measuring Money 1) The Fed's narrowest measure of money is ________. A) M1 B) M2 C) M3 D) all of the above E) none of the above Answer: A Topic: 5.3 Measuring Money 2) M1 differs from M2 because ________. A) M2 includes components that are less liquid than any component of M1 B) M1 does not include savings deposits and M2 does C) M1 is included in M2 but M2 has more components D) all of the above E) none of the above Answer: D Topic: 5.3 Measuring Money 3) M1 differs from M2 because ________. A) M1 includes demand deposits and M2 does not B) M1 includes currency held by the nonbank public and M2 includes only currency held by banks C) M1 includes non interest-bearing checking accounts and M2 includes interest bearing time deposit accounts D) all of the above E) none of the above Answer: C Topic: 5.3 Measuring Money

7 Copyright © 2012 Pearson Education, Inc.

4) M1 differs from M2 because ________. A) M1 is less liquid than M2 B) M1 includes demand deposits and M2 does not C) M1 includes only the most liquid forms of money and M2 includes all of M1 and some less liquid items D) all of the above E) none of the above Answer: C Topic: 5.3 Measuring Money 5) M1 does not include cash that is held in ATMs or bank vaults, because ________. A) no one really owns that money B) that money is included in M2 C) that money earns no interest D) the right to access that money is counted already as bank deposits E) none of the above Answer: D Topic: 5.3 Measuring Money 6) Financial innovations such as direct deposit of paychecks, electronic payment of bills, and automated teller machines (ATMs) have likely ________. A) had minimal effect on M1 and M2 B) reduced the size of M2 relative to M1 C) increased both M1 and M2 relative to GDP D) caused the growth rates of M1 and M2 to become more stable E) reduced the size of M1 relative to M2 Answer: E Topic: 5.3 Measuring Money AACSB: Reflective Thinking 7) Typically, when someone borrows money from a bank, M2 ________, because ________. A) increases; the money is held for a while in a liquid form B) decreases; the money is held for a while in a liquid form C) does not change; the loan affects only the subcategories within M2 D) decreases; of the decline in the bank's vault cash E) none of the above Answer: A Topic: 5.3 Measuring Money 8) Which of these transactions results in an increase in M1? A) withdrawal of $100 cash from your checking account B) certificate of deposit matures, adding $520 to your checking account C) depositing a bank loan of $400 into your savings account D) depositing a $300 paycheck into your savings account E) none of the above Answer: B Topic: 5.3 Measuring Money 8 Copyright © 2012 Pearson Education, Inc.

9) Which of these transactions results in an increase in M2? A) certificate of deposit matures, adding $520 to your checking account B) withdrawal of $100 cash from your checking account C) depositing a bank loan of $400 into your savings account D) depositing a $300 paycheck into your savings account E) none of the above Answer: C Topic: 5.3 Measuring Money 10) If the euro replaces the U.S. dollar as the world's most popular currency, that will likely ________. A) reduce M1, without affecting M2 B) reduce M2, without affecting M1 C) cause a temporary increase in M1 D) affect neither M1 nor M2 E) none of the above Answer: E Topic: 5.3 Measuring Money AACSB: Reflective Thinking 11) As of 2010 the outstanding U.S. currency is $872 billion, which implies that the typical U.S. citizen holds $2,800 in cash. Is this an accurate inference? Why? A) Yes; because dividing total currency of $872 billion by total U.S. population in 2010 roughly works out to $2,800 per person B) No; because criminals and foreigners hold large sums of dollars, so the average citizen holds far less. C) No; because the average citizen probably does not have $2800 in her checking account to back up all that cash D) Yes; because the Fed rarely makes accounting mistakes when computing M1 E) none of the above Answer: B Topic: 5.3 Measuring Money 12) The principal reason(s) that so much U.S. currency is held outside the U.S is (are) ________. A) many people around the world trust the U.S. dollar more than any other currency B) banks all around the world find it convenient to hold large amounts of U.S. dollars C) U.S. citizens and corporations spend a lot of dollars abroad D) all of the above E) none of the above Answer: A Topic: 5.3 Measuring Money

9 Copyright © 2012 Pearson Education, Inc.

13) Recent financial turmoil has caused many people to increase saving and to prefer assets that are perceived to be relatively safe and liquid. What are the likely effects on M1 and M2? Answer: Increased saving implies reduced consumption, so holding of the most liquid assets, M1, should decline. Instead, people will hold more of the less liquid, interest-bearing assets within M2. If people are shifting away from illiquid assets like corporate stock in favor of assets like money market mutual fund shares, then M2 should rise. Topic: 5.3 Measuring Money AACSB: Reflective Thinking 14) Credit cards are a popular means of payment. Why are credit card accounts not included in M1 or M2? Are credit cards of no relevance to these money measures? Answer: A purchase using a credit card is the same as taking out a loan. In the transaction, no medium of exchange passes between the buyer and the seller. At a later time, the seller receives a payment, and the buyer must give a corresponding amount to the credit card issuer. The use of credit cards does tend to reduce M1 relative to M2, since many transactions can be covered by a single monthly payment on ones credit card account, reducing the desired quantities of cash and checking account balances. Topic: 5.3 Measuring Money AACSB: Reflective Thinking 5.4 Quantity Theory of Money 1) The quantity theory of money ________. A) is the product of classical economists B) links total income to a country's supply of money C) is derived from the equation of exchange D) all of the above E) none of the above Answer: D Topic: 5.4 Quantity Theory of Money 2) The quantity theory of money ________. A) is the product of Keynesian economists B) links total income to a country's supply of money C) explains why the equation of exchange is true by definition D) all of the above E) none of the above Answer: B Topic: 5.4 Quantity Theory of Money

10 Copyright © 2012 Pearson Education, Inc.

3) The quantity theory of money ________. A) was best explained by Fisher's book"The Purchasing Power of Money" B) links total money supply to a country's demand for money C) explains why the equation of exchange is true by definition D) all of the above E) none of the above Answer: A Topic: 5.4 Quantity Theory of Money 4) The quantity theory of money explains how ________ depends on ________. A) real GDP; the money supply B) the price level; the demand for money C) the money supply; the velocity of money D) all of the above E) none of the above Answer: E Topic: 5.4 Quantity Theory of Money 5) The velocity of money ________. A) represents the average number of times a dollar turns over through the year B) provides the link between the money supply and nominal income C) times the money supply should equal total income according to the equation of exchange D) all of the above E) none of the above Answer: D Topic: 5.4 Quantity Theory of Money 6) The velocity of money ________. A) represents the average number of times a dollar is spent in a given year B) provides the link between the money supply and money demand C) times the money supply should equal real GDP D) all of the above E) none of the above Answer: A Topic: 5.4 Quantity Theory of Money 7) The equation of exchange ________. A) states that the quantity of money multiplied by velocity must equal nominal income in a given year B) describes a relationship that is true by definition C) shows that real GDP must equal real money balances times the number of times a dollar turns over in a year D) all of the above E) none of the above Answer: D Topic: 5.4 Quantity Theory of Money 11 Copyright © 2012 Pearson Education, Inc.

8) The equation of exchange ________. A) states that the quantity of money divided by velocity must equal nominal income in a given year B) is only an identity if we do not understand the determinants of velocity C) shows that nominal income must equal real money balances times the number of times a dollar turns over in a year D) all of the above E) none of the above Answer: B Topic: 5.4 Quantity Theory of Money 9) According to Irving Fisher, velocity ________. A) is determined by institutions that affect the way individuals transact B) is affected by institutions only gradually C) is assumed constant in the short run D) all of the above E) none of the above Answer: D Topic: 5.4 Quantity Theory of Money 10) According to Irving Fisher, velocity ________. A) is determined by the way banks alone conduct transactions B) equals the number of transactions times the average price per transaction all divided by total money balances C) can change very quickly on short notice D) all of the above E) none of the above Answer: B Topic: 5.4 Quantity Theory of Money 11) The quantity theory of money ________. A) is formulated in terms of aggregate output because the nominal value of transactions is difficult to measure B) assumes that the nominal value of transactions are a constant portion of aggregate output C) assumes velocity is constant in the short run D) all of the above E) none of the above Answer: D Topic: 5.4 Quantity Theory of Money

12 Copyright © 2012 Pearson Education, Inc.

12) The quantity theory of money ________. A) is formulated in terms of aggregate output because the nominal value of transactions is difficult to measure B) tells us how much money is held for a given amount of nominal spending C) implicitly tells us the quantity of money that people want to hold D) all of the above E) none of the above Answer: D Topic: 5.4 Quantity Theory of Money 13) The quantity theory of money tells us that real money balances are proportional to income, since ________. A) velocity is assumed constant in the short run B) the supply and demand of money are equal in equilibrium C) changes in the quantity of money lead to proportional changes in the price level D) all of the above E) none of the above Answer: D Topic: 5.4 Quantity Theory of Money 14) From the equation of exchange, if both nominal income and the quantity of money (M) triple, the price level (P) increases by 50 percent and velocity (V) remains constant, then real output (Y)________. A) also triples B) increases by 50 percent C) doubles D) decreases by 50 percent E) none of the above Answer: C Topic: 5.4 Quantity Theory of Money 15) From the equation of exchange, if both nominal income and the quantity of money (M) double, the price level (P) decreases by 50 percent and velocity (V) remains constant, then real output (Y)________. A) also doubles B) triples C) quadruples D) decreases by 50 percent E) none of the above Answer: C Topic: 5.4 Quantity Theory of Money

13 Copyright © 2012 Pearson Education, Inc.

16) From the equation of exchange, if both real income (Y) and the quantity of money (M) double and the price level (P) remains constant, then velocity (V)________ and nominal income ________. A) remains constant; doubles B) doubles; remains constant C) doubles; doubles D) decreases by 50 percent; quadruples E) none of the above Answer: A Topic: 5.4 Quantity Theory of Money 17) In the quantity theory of money, which of these variables is endogenous? A) the price level B) the velocity of money C) real output D) the money supply E) none of the above Answer: A Topic: 5.4 Quantity Theory of Money 18) In the quantity theory of money, the assumption that aggregate output is fixed is based on the view that ________. A) wages and prices are perfectly flexible in the long run B) the velocity of money is constant in the short run C) the demand for real money balances is proportional to income D) changes in the quantity of money lead to proportional changes in the price level E) none of the above Answer: A Topic: 5.4 Quantity Theory of Money 19) The quantity theory of money ________. A) is used by classical economist to explain how changes in the quantity of money lead to proportional changes in the price level. B) gives mathematical grounding for the view that a country's central bank determines the general price level through control of the money supply. C) implies that changes in the money supply have no long run impact on real variables D) all of the above E) none of the above Answer: D Topic: 5.4 Quantity Theory of Money AACSB: Reflective Thinking

14 Copyright © 2012 Pearson Education, Inc.

20) The quantity theory of money ________. A) is used by classical economists to explain how frequent changes in velocity lead to infrequent changes in the price level. B) gives mathematical grounding for the view that a country's central bank determines the general price level through control of the money supply. C) implies that changes in the money supply never have an impact on real variables D) all of the above E) none of the above Answer: B Topic: 5.4 Quantity Theory of Money AACSB: Reflective Thinking 21) The proposition that changes in the money supply have no long-run effect on real variables is known as the ________. A) classical dichotomy B) quantity theory of money C) neutrality of money D) Fisher effect E) none of the above Answer: C Topic: 5.4 Quantity Theory of Money 22) The proposition that the amount of goods and services produced in an economy in the long run is not affected by the price level is known as the ________. A) neutrality of money B) classical dichotomy C) quantity theory of money D) Fisher effect E) none of the above Answer: B Topic: 5.4 Quantity Theory of Money 23) The proposition that the velocity of money is fairly constant in the long run is known as the ________. A) neutrality of money B) classical dichotomy C) quantity theory of money D) Fisher effect E) none of the above Answer: E Topic: 5.4 Quantity Theory of Money

15 Copyright © 2012 Pearson Education, Inc.

24) The quantity theory of money ________. A) implies that inflation equals the ratio of the growth rates of the money supply and of real income B) provides central banks with a tool to prevent the rate of inflation from fluctuating C) implies that, in the long run, changes in the money supply will be matched by changes in real income D) all of the above E) none of the above Answer: E Topic: 5.4 Quantity Theory of Money AACSB: Reflective Thinking 25) The quantity theory of money ________. A) focuses mainly on the close link between short run fluctuations in velocity and the price level B) works very well for the U.S. but it does not hold empirically for other countries in the long run C) provides a long run theory of inflation because it is based on the assumption that prices and wages are fully flexible D) all of the above E) none of the above Answer: C Topic: 5.4 Quantity Theory of Money AACSB: Reflective Thinking 26) The quantity theory of money ________. A) suggests that inflation is always and everywhere a monetary phenomenon which has been shown to always be supported by the data B) validates the classical assumption that wages and prices are completely flexible in the short run C) provides a better description of short run fluctuations in inflation and money growth than the link between these variables in the long run D) all of the above E) none of the above Answer: E Topic: 5.4 Quantity Theory of Money AACSB: Reflective Thinking 27) How have financial innovations such as direct deposit of paychecks, electronic payment of bills, and automated teller machines (ATMs) affected the velocity of money and the demand for real money balances? Answer: Because of these innovations, each unit of money is more quickly and easily available for transactions. Each unit of money is transacted more frequently, so velocity is increased. A given volume of transactions can be accomplished with fewer units of money, so the demand for real balances is reduced. Topic: 5.4 Quantity Theory of Money AACSB: Reflective Thinking 16 Copyright © 2012 Pearson Education, Inc.

28) Suppose Y = 100, P = 80, and V = 3.2. If Y rises to 105, and the inflation rate is 10 percent, what is the new value of M? Answer: 105 × 88 = 9,240 = M × 3.2. M = 2,887.5. Equivalently, 100 × 80 = M × 3.2, so M = 2,500. Since P × Y rises from 8,000 to 9,240, an increase of 15.5%, M must rise by 15.5% = 2,500 × 1.155 = 2,887.5 Topic: 5.4 Quantity Theory of Money AACSB: Analytical Skills 5.5 Hyperinflation, Inflation and Interest Rates 1) Hyperinflation typically ________. A) describes periods of extreme price increases of over 50% per month or 1,000% per year B) is a a result of extreme periods of money growth that tend to come only from large fiscal imbalances C) affects both poor and developed economies D) all of the above E) none of the above Answer: D Topic: 5.5 Inflation AACSB: Reflective Thinking 2) The main reason that hyperinflation renders a currency worthless is that ________. A) the government cannot print money fast enough to keep up with the rising prices B) laws against raising prices are easily evaded C) reducing government expenditures is politically unpopular D) the government's "official" inflation rate is always a gross understatement E) as soon as inflation seems out of control, everyone knows that the currency will soon lose whatever value it has today Answer: E Topic: 5.5 Inflation AACSB: Reflective Thinking 3) The real interest rate ________ inflation ________. A) is unaffected in the long run by; because of the classical dichotomy B) moves one for one with expected; in the long run C) always increases with; but because of the Fisher effect lower expected inflation ensues D) all of the above E) none of the above Answer: A Topic: 5.5 Inflation AACSB: Reflective Thinking

17 Copyright © 2012 Pearson Education, Inc.

4) The real interest rate ________ inflation ________. A) subtracted from the nominal rate yields expected; according to the Fisher equation B) moves one for one, in the long run, with expected; according to the classical dichotomy C) always increases with; but because of the Fisher effect lower expected inflation ensues D) all of the above E) none of the above Answer: A Topic: 5.5 Inflation AACSB: Reflective Thinking 5) The Fisher effect ________. A) comes from combining the Fisher equation and the classical dichotomy B) predicts that in the long run nominal rates will rise with increases in expected inflation C) shows that in high inflation we typically see high nominal rates D) all of the above E) none of the above Answer: D Topic: 5.5 Inflation AACSB: Reflective Thinking 6) Inflation ________. A) is costly because the classical dichotomy may not always hold B) that is anticipated (or expected) can be costly C) is costly for many reasons but chief among them is that inflation makes it more difficult to plan for the future D) all of the above E) none of the above Answer: D Topic: 5.5 Inflation AACSB: Reflective Thinking 7) With increases in inflation demand for money that does not earn a return decreases. Carrying less cash in our pockets means higher ________. A) shoe-leather costs B) menu costs C) capital gain tax bills D) all of the above E) none of the above Answer: A Topic: 5.5 Inflation AACSB: Reflective Thinking

18 Copyright © 2012 Pearson Education, Inc.

8) With high inflation ________. A) stock market investors are always worse off than consumers and households B) producers are always worse off than consumers C) creditors are always worse off than debtors D) all of the above E) none of the above Answer: C Topic: 5.5 Inflation AACSB: Reflective Thinking 9) Inflation might lead to ________ because ________. A) lower demand for stocks; of tax distortions B) lower demand for cash; money does not typically yield interest C) uncertain or uneven demand for goods; higher fluctuations in relative prices make it harder for consumers to compare among goods and make rational consumption decisions D) all of the above E) none of the above Answer: D Topic: 5.5 Inflation AACSB: Reflective Thinking 10) Inflation might lead to ________ because ________. A) higher demand for stocks; as the price level increases so do stock prices B) higher production costs; businesses have to advertise more often due to faster price revisions C) lower transaction costs; we would hold less cash D) all of the above E) none of the above Answer: B Topic: 5.5 Inflation AACSB: Reflective Thinking 11) Inflation ________. A) is more costly when it is anticipated than when it comes as a surprise B) makes it more difficult to plan for the future, whether it is a surprise or not. C) induces distortions in the money and goods market but not the labor market D) all of the above E) none of the above Answer: B Topic: 5.5 Inflation AACSB: Reflective Thinking

19 Copyright © 2012 Pearson Education, Inc.

12) Inflation leads to ________. A) increased variability of relative prices only when it is anticipated B) increased variability of relative prices only when it is unanticipated C) increased variability of relative prices whether inflation is anticipated or not D) lower variability of the general price level only when it is very high E) none of the above Answer: C Topic: 5.5 Inflation AACSB: Reflective Thinking 13) Inflation may impose little, if any, cost on the economy, if ________. A) laws against excessive price increases are enforced effectively B) the government subsidizes menu costs C) price increases are fully anticipated D) the Fisher effect holds true E) the rate of price increase is so slow that people do not feel compelled to alter their behavior Answer: E Topic: 5.5 Inflation AACSB: Reflective Thinking 14) During the Great Inflation of the 1970s, (a) the growth rates of M1 and M2 were higher than previously, and (b) the growth rate of M2 was much higher than the growth rate of M1. Explain how the high inflation of the decade relates to each of these facts . Answer: By the quantity theory of money, rapid growth of the money supply (relative to the growth rate of aggregate output) causes the inflation rate to be high. When inflation is high, holding cash and non-interest bearing deposits is costly, so people shift as much money as possible into interest-bearing accounts, so the narrow monetary aggregate M1 does not grow as fast as the broader aggregate M2. By the Fisher effect, nominal interest rates rise with expected inflation, so interest-bearing accounts provide some compensation for inflation. Topic: 5.5 Inflation AACSB: Reflective Thinking 15) Inflation interferes with the functions of money. Which of the three functions is impaired, even when the inflation rate is quite low? Considering higher rates of inflation, which function is affected next? Which function of money is the last to suffer substantial damage from inflation? Answer: A consequence of even low inflation is to undermine money's function as a store of value. At somewhat higher rates, inflation complicates the use of money as a unit of account, because of increased variability of relative prices. As the inflation rate goes higher, money loses its ability to serve as a medium of exchange. Topic: 5.5 Inflation AACSB: Reflective Thinking

20 Copyright © 2012 Pearson Education, Inc.

16) How might inflation, even if fully anticipated, prevent the classical dichotomy from holding, even in the long run? Answer: The classical dichotomy asserts that output is determined solely by the aggregate production function and the quantities of factors available. Inflation is like a negative technology shock that lowers productivity. Shoe-leather and menu costs represent uses of resources that add nothing to aggregate output. Because price increases throughout the economy are spread out over time, it is rational to react to the temporary changes in relative prices, even if the changes are known to be temporary. This causes distortions in the allocation of resources, and temporary, rational distortions are distortions, nonetheless. Topic: 5.5 Inflation AACSB: Reflective Thinking 17) Unanticipated inflation always benefits somebody, so the overall cost cannot be higher than it is for anticipated inflation. Comment. Answer: It is true that mistaken expectations of inflation cause one party to a transaction to get a better deal than intended, at the expense of the other party. But the true value of that better deal is reduced by the fact that neither party knows, in advance, who will win. Few workers, for example, would prefer to be paid on the basis of a lottery in which losing is as likely as winning. Moreover, unanticipated inflation is difficult to recognize, even after the fact. If the size of your nominal wage increase exceeds your expectation of inflation, does that mean your real wage is higher, or that your expectation was mistaken? By the time you figure it out, you may have made a wrong decision. Topic: 5.5 Inflation AACSB: Reflective Thinking 5.6 Inflation and Interest Rates 1) There are no questions for this section. Answer: 5.7 The Cost of Inflation 1) There are no questions for this section. Answer:

21 Copyright © 2012 Pearson Education, Inc.