Chapter 16

PROBLEMS

1. In the economy of Scottopia, policy makers want to lower the unemployment rate and raise

real GDP by using monetary policy. Using the accompanying diagram, show why this policy

will ultimately result in a higher aggregate price level but no change in real GDP.

2. In the following examples, would the classical model of the price level be a useful model for

analyzing how the economy behaves?

a. The economy has high unemployment and no history of inflation.

b. The economy has just experienced five years of hyperinflation.

c. Although the economy experienced inflation in the 10% to 20% range three years ago,

prices have recently been stable and the unemployment rate has approximated the natural

rate of unemployment.
4. Answer the following questions about the (real) inflation tax, assuming that the price level

starts at 1.

a. Maria keeps $1,000 in her sock drawer for a year. Over the year, the inflation rate is 10%.

What is the real inflation tax paid by Maria for this year?

b. Maria continues to keep the $1,000 in her sock drawer for a second year. What is the real

value of this $1,000 at the beginning of the second year? Over the year, the inflation rate is

again 10%. What is the real inflation tax paid by Maria for the second year?

c. For a third year, Maria keeps the $1,000 in the drawer. What is the real value of this $1,000

at the beginning of the third year? Over the year, the inflation rate is again 10%. What is the

real inflation tax paid by Maria for the third year?

d. After three years, what is the cumulative real inflation tax paid?

e. Redo parts a through d with an inflation rate of 25%. Why is hyperinflation such a problem?

5. The inflation tax is often used as a significant source of revenue in developing countries where

the tax collection and reporting system is not well developed and tax evasion may be high.

a. Use the numbers in the accompanying table to calculate the inflation tax in the United

States and India (Rp = rupees).

 Central

government

Inflation Money supply in receipts in 2019

in 2019 2019 (billions) (billions)

India 7.66% Rp36,883 Rp12,828

United States 1.81% $3,981 $3,331

Data from: Bureau of Economic Analysis; Controller General of Accounts

(India); Reserve Bank of India; International Monetary Fund; The World

Bank.

b. How large is the inflation tax for the two countries when calculated as a percentage of

government receipts?

6. Concerned about the crowding-out effects of government borrowing on private investment

spending, a candidate for president argues that the United States should just print money to

cover the government’s budget deficit. What are the advantages and disadvantages of such a

plan?

7. The accompanying scatter diagram shows the relationship between the unemployment rate and

the output gap in the United States from 1996 to 2019. Draw a straight line through the scatter

of dots in the figure. Assume that this line represents Okun’s law:
 Unemployment rate = b − (m × Output gap)

where b is the vertical intercept and −m is the slope

What is the unemployment rate when aggregate output equals potential output? What would

the unemployment rate be if the output gap were 2%? What if the output gap were −3%? What

do these results tell us about the coefficient m in Okun’s law?

8. After experiencing a recession for the past two years, the residents of Albernia were looking

forward to a decrease in the unemployment rate. Yet after six months of strong positive

economic growth, the unemployment rate has fallen only slightly below what it was at the end

of the recession. How can you explain why the unemployment rate did not fall as much

although the economy was experiencing strong economic growth? (Hint: Reread the For

Inquiring Minds box on Okun’s law for help with answering this question.)
9. a. Go to [Link]. Click on link “Subjects”; on the left, under “Inflation & Prices,” click

on the link “Consumer Price Index,” then under the heading “CPI Data,” select “ Tables”

and then “Archived CPI Detailed Reports.” Download the file for “2009 Detailed Reports”

and open file [Link]. What is the value of the percent change in the CPI from 2008 to

2009?

b. Now go to [Link] and under the tab “Data” and “Interest Rates” select “Daily

Treasury Bill Rates” and select “2009” under “Select Time Period.” Examine the data in “4

Weeks Bank Discount.” What is the maximum? The minimum? Then do the same for 2007.

How do the data for 2009 and 2007 compare? How would you relate this to your answer in

part a? From the data on Treasury bill interest rates, what would you infer about the level of

the inflation rate in 2007 compared to 2009? (You can check your answer by going back to

the [Link] website to find the percent change in the CPI from 2006 to 2007.)

c. How would you characterize the change in the U.S. economy from 2007 to 2009? What

were the implications for the effectiveness of monetary policy?

10. The economy of Brittania has been suffering from high inflation with an unemployment rate

equal to its natural rate. Policy makers would like to disinflate the economy with the lowest

economic cost possible. Assume that the state of the economy is not the result of a negative

supply shock. How can they try to minimize the unemployment cost of disinflation? Is it

possible for there to be no cost of disinflation?

11. Who are the winners and losers when a mortgage company lends $100,000 to the Miller

family to buy a house worth $105,000 and during the first year prices unexpectedly fall by

10%? What would you expect to happen if deflation continued over the next few years? How

would continuing deflation affect borrowers and lenders throughout the economy as a whole?