HS-203: Introduction to Economics

Tutorial 5
Questions

September 5, 2025

1. A government is facing rising inflation and large public debt. To ease the burden of
debt servicing, it imposes a ceiling on nominal interest rates at 7%, even though lenders
expect inflation to average 8% in the coming years.
(a) Calculate the real return to lenders under this policy.
(b) From the perspective of lenders, savers, and financial institutions, explain how this
policy might change their behavior in the short run.
(c) Discuss the potential long-term effects on financial intermediation and economic
growth if such interest rate caps persist.
2. (a) The Quantity Theory of Money is expressed as
MV = PY
where:
• M = Money supply
• V = Velocity of money
• P = Price level
• Y = Real output
Suppose in an economy:
M = 1000 billion, V = 4, Y = 2000 billion units.
(a) Calculate the price level P .
(b) If money supply increases by 20% while V and Y remain unchanged, find the
new price level.
(b) The Quantity Theory of Money assumes that velocity of money is constant in the
short run. Critically evaluate this assumption. Under what circumstances might
velocity change, and how would that affect the relationship between money supply
and price level?

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3. Milton Friedman argued that “inflation is always and everywhere a monetary phe-
nomenon.” Using the Quantity Theory of Money (MV = PY), assess this claim in the
following scenarios:
• Case 1 (2000–2010): Country X’s money supply grew at 12% annually, while
real GDP grew at 5% per year. Velocity remained roughly constant, and inflation
averaged close to 7%.
• Case 2 (2020–21): The same country experienced a one-year inflation spike of
10% due to a global oil shock, even though money supply growth remained mod-
erate.
Question: In which case does Friedman’s claim fit better, and why? Under what assump-
tions does his statement hold strictly true?
4. What is the economic phenomenon called when an economy experiences rising inflation
alongside falling output? Explain how supply shock will lead to this phenomenon and
discuss the challenges it creates for monetary policy.
5. List three most important tools of monetary policy that the RBI employs to control high
inflation due to higher aggregate demand and explain their mechanism briefly?

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Answers:
1. (a) Real returns= -1.
(b) • Lenders and savers are likely to withdraw funds from regulated financial in-
struments such as bank deposits and bonds, redirecting them instead into
assets that hold value against inflation, such as real estate, gold, or foreign
currencies.
• Financial institutions may reduce lending, experience liquidity strains, and
reallocate resources to safeguard returns, ultimately causing disintermediation
and a credit crunch.
(c) Long-term effects are:
• Reduced financial intermediation – Negative real returns discourage savings
in banks, shrinking the pool of funds available for lending.
• Credit constraints – Banks tighten lending standards and impose higher fees,
making credit harder and more expensive for businesses and households.
• Slower economic growth – Lower investment and inefficient capital allocation
reduce long-run productivity and output.
2. (a)
MV 1000 × 4
P = = =2
Y 2000

If M rises by 20%, then

M ′V 1200 × 4
P′ = = = 2.4
Y 2000

(b) The assumption of constant V is a simplification. In practice, velocity can vary due
to:
• changes in payment technologies (digital payments, credit cards),
• interest rates and the opportunity cost of holding money,
• uncertainty and expectations (precautionary balances),
• financial and institutional developments,
• phases of the business cycle.
In growth-rate form:
∆P ∆M ∆V ∆Y
≈ + − .
P M V Y

Thus, if V decreases, inflation may be lower than expected, and if V increases,

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3. • Friedman’s claim fits Case 1 more directly. With velocity stable, the Quantity The-
ory (MV = PY) implies that inflation should equal money supply growth minus
real GDP growth (12% – 5% = 7%). This matches the observed outcome, showing
that sustained inflation arose from excess monetary growth — exactly as Fried-
man predicted. In Case 2, the inflation spike was driven by a temporary supply
shock (higher oil prices), not monetary expansion. While Friedman’s theory does
not explain this short-run surge, such cost-push inflation typically fades unless it
is accommodated by continued money growth. Thus, short-term deviations can
occur, but persistent inflation ultimately requires excess monetary growth. Fried-
man’s statement holds strictly true in the long run, under the assumptions of stable
velocity, full employment of output, and no repeated supply shocks. Under these
conditions, sustained inflation is indeed “a monetary phenomenon.”
4. The situation is called stagflation. Stagflation occurs when the economy experiences
high inflation alongside falling output. It often arises from a negative supply shock.
Suppose there is a sudden increase in energy prices (oil or gas or electricity):
• A sudden increase in key input costs, such as energy prices, raises production
costs for firms, especially those in energy-intensive sectors like transportation and
manufacturing.
• To maintain profits, firms increase the prices of goods and services, generating
cost-push inflation.
• Higher costs make some firms unprofitable; they may reduce output or exit the
market, which decreases the overall supply of goods and services in the economy.
• The Short-Run Aggregate Supply (SRAS) curve shifts leftward, resulting in a higher
price level and lower output at the new equilibrium.
This creates challenges for monetary policy:
• Lowering interest rates can stimulate demand and slightly boost output, but it risks
further increasing inflation.
• Raising interest rates can help control inflation, but it reduces aggregate demand
and output, worsening the economic slowdown.
5. (a) Repo Rate
The repo rate is the interest rate at which the RBI lends short-term funds to com-
mercial banks. When inflation is high due to excess demand, the RBI increases
the repo rate. This makes borrowing costlier for banks, which in turn raise their
lending rates to businesses and consumers. Higher borrowing costs reduce credit
demand, lower consumption and investment, and ultimately help curb inflation.
(b) Cash Reserve Ratio (CRR)
CRR is the proportion of a bank’s net demand and time liabilities (NDTL) that must
be kept as cash with the RBI. An increase in CRR means banks have less money
to lend, tightening liquidity in the economy. This reduces the availability of credit
and lowers aggregate demand, thereby easing inflationary pressures.

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(c) Open Market Operations (OMO)
OMO involves the RBI buying or selling government securities in the open market
to manage liquidity. During high inflation, the RBI sells government securities to
absorb excess money from the banking system. This contraction of liquidity limits
credit creation and reduces aggregate demand, helping to stabilize prices.