Which of the following two statements involves positive economic analysis and which
Economics 1 — Semester 2 — Tutorial Sheet 8 — Week 9
Money and Inflation in the Long Run
Required reading
- Recent lecture notes
- Nils Gottfries, Macroeconomics, Chapter 7
(Note: it is assumed here and will be assumed in the exam that you are familiar with the
terminology laid out on pages xxvi - xxvii of Gottfries’ text.)
Homework
- Submission of homework this semester works like semester 1, but there is now
one additional component – you must also submit a graph.
- The submission must be done via Learn by 5pm on the Sunday before the tutorials
occur.
- The written homework, as before, should be equivalent to at least two sides of
handwritten A4 and should be clear enough to read. Again, it does not need to be
complete, and indeed it does not even need to be co
ect. You just need to show
that you have made an honest attempt. As long as you have shown an honest
attempt, you will get credit, and as long as you do this for 14 of the 18 tutorials
during the year, you will get full credit.
- NEW FOR SEMESTER 2: you must also submit an additional page with a ‘looking
at the data’ graph (this will be different each week, and relevant information will
e on each tutorial sheet).
Further resources
- Gottfries on YouTube: the textbook author (Nils Gottfries) has put 15-40 minute
videos from most chapters of the book on YouTube:
o https:
goo.gl/Wq8o82
- FRED: Most of the tutorial sheets this semester contain graphs generated by the
St. Louis Fed’s Federal Reserve Economic Data (FRED) site. This is a surprisingly
easy-to-use, free site for exploring hundreds of thousands of economic data series.
You are strongly encouraged to visit the site whenever you feel the need to find
out what’s happened lately to GDP growth, or inflation, or infant mortality, etc.
o http:
esearch.stlouisfed.org/fred2
Recordings:
- Questions marked with an asterisk* have video solutions recorded by Sean, which
will be released after the Sunday 5pm submission deadline. Because the asterisk
questions are covered in video, they will mostly not be covered within the
tutorials themselves.
https:
goo.gl/Wq8o82
http:
esearch.stlouisfed.org/fred2
Looking at the data
Using FRED (or another data source) find and print a graph of M1 growth and inflation for
a country of your choice. Include comments on any trends or features in the data and
ing
the printed graph and comments to your tutorial.
The Bank of England
Like all models, the models of money creation in this chapter are simplifications. For a somewhat
more in-depth view of how money is created, the Bank of England did a couple of nice articles in
their 1st quarterly bulletin of 2014. These are interesting (but not examinable):
https:
www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-in-the-modern-economy-an-introduction
https:
www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy
Tutorial Questions
* Q1. Go to the Federal Reserve Economic Data (FRED) site and look up the inflation rates
for any three of the G7 economies (Britain, France, Germany, Italy, Japan, Canada and the
United States). What similarities do you notice? Can you summarise the history of the G7
inflation rates as a series of three or four stages?
* Q2. What is the effect on credit markets of each of the following? Make sure to specify and
explain who (if anyone) wins, and who loses.
(a) Unexpected inflation
(b) Unexpected disinflation
(c) Expected inflation
(d) Expected disinflation
* Q3. Discuss the following statements:
(a) “Inflation is destructive.”
(b) “Without inflation we would have been much better off.”
(c) “Inflation is a tax.”
(d) “Without inflation there would be no seignorage for the central bank.”
Q4. Which one of these countries do you think had the highest ever monthly inflation rate?
(You are encouraged to take a wild guess without looking it up beforehand.)
i. China
ii. Germany
iii. Greece
iv. Hungary
v. Yugoslavia
vi. Zimbabwe
Q5. The opportunity cost of holding money is said to be the nominal interest rate. Why is it
the nominal rather than the real interest rate?
Q6. Discuss whether the following items qualify as ‘money’ in the sense that they have the
four characteristics that money has in the theory presented in the textbook:
(a) Gold
(b) Dollar bills
(c) Money in an ISA savings account
(d) A credit card
(e) Foreign cu
ency
(f) Banks’ claims in the payment system (reserves)
Q7.
(a) What is the monetary base?
(b) Is it possible to make purchases without using monetary base?
(c) Is it possible to make loans and pay interest without using monetary base?
(d) Does the central bank have perfect control of the monetary base?
Q8. Give some examples of events that could increase the amount of monetary base needed
to make a given amount of transactions.
Q9. Discuss how the following may affect the demand for monetary base:
(a) Because of high inflation, people start to use foreign cu
ency for large payments.
(b) Because of financial uncertainty, banks start to hold more money in their accounts
in the payment system.
(c) It becomes possible to pay with credit cards on buses and trains.
Q10. Consider the following graphs of the US data since 1960 on the price level1 (top left),
money supply2 (top right), real output3 (bottom left) and the velocity of money4 (bottom
ight). Note that US recessions are shaded in grey.
When applying the quantity theory of money ?? = ??, or the rule-of-thumb version of it
ased on growth rates, we often treat velocity as constant in the long run. Is this a
easonable simplification? Are there times when the V-is-constant approximation would
have been particularly unhelpful?
Q11. The money supply increases 10% in a year. What is the inflation rate if…
(a) …real production and velocity are constant
(b) …real production grows 4 percent and velocity is constant
1 US. Bureau of Labor Statistics, Consumer Price Index for All U
an Consumers: All Items [CPIAUCSL], retrieved from FRED,
Federal Reserve Bank of St. Louis https:
esearch.stlouisfed.org/fred2/series/CPIAUCSL/, January 1, 2015.
2 Board of Governors of the Federal Reserve System (US), M2 Money Stock [M2SL], retrieved from FRED, Federal Reserve
Bank of St. Louis https:
esearch.stlouisfed.org/fred2/series/M2SL/, January 1, 2015.
3 US. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED, Federal Reserve Bank of
St. Louis https:
esearch.stlouisfed.org/fred2/series/GDPC1/, January 1, 2015.
4 Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St.
Louis https:
esearch.stlouisfed.org/fred2/series/M2V/, January 1, 2015.
(c) …real production is constant and velocity decreases from 2 to 1.8
Q12. We know that ?? = ??. Solving for Y we get ? = ??/? and, using our rule of thumb
for growth rates, we have ?? ?⁄ = ?? ?⁄ + ?? ?⁄ − ?? ?⁄ . Apparently, this equation says
that inflation will reduce real growth. One percent higher inflation means one percent
lower real growth. Is this true or is there any mistake in this argument? (Hint: Think about
exogenous and endogenous variables.)
* Q13. ‘High inflation is a tax on people who save.’ Is this true or false?
* Q14. ‘Higher expected inflation in the future will raise inflation today.’ Is this true or false?
If true, clarify the conditions under which the statement may be true.
Q15. In 2004 GDP in the USA was $11 876 billion dollars and in 2005 it was $12 718 billion
dollars. The monetary base was $759 billion in 2004 and $787 billion in 2005.
(a) Calculate the velocity of the monetary base in 2004 and 2005.
(b) Calculate seignorage relative to GDP in 2005.
(c) Calculate what seignorage would have been if velocity had remained unchanged
etween 2004 and 2005.
(d) Explain the difference between the results in (b) and (c).
Q16. Suppose that the velocity of the monetary base is 20, real GDP grows 3% per year and
inflation is 2%.
(a) Calculate seignorage relative to GDP.
(b) Calculate seignorage relative to GDP if the real growth rate is instead 8% and
velocity remains unchanged.
(c) Calculate seignorage relative to GDP if inflation is instead 7% and velocity remains
unchanged.
(d) Would you expect velocity to be the same in cases (b) and (c) as in (a)? Consider
oth the short and the long run.
(e) Is the result in (c) an over- or underestimation of the increase in seignorage?
Q17. Assume that velocity is determined by the function ? = ?????, where ?? is the ‘base’
velocity, b is a parameter, and t, the nominal interest rate i is determined by ? = ?? + ?,
where the natural (real) rate of interest, ??, is taken as given.
(a) Write down an expression for seignorage