## Money and Inflation

Economics 100b; Spring 1996; Brad DeLong

1. Up until this week, we have focused on quantities and relative prices. This week we focus on prices expressed in terms of units of money. What terms do economists use to distinguish between these two groups of concepts and magnitudes?

• "Real" for concepts that describe quantities produced and relative prices; "nominal" for values expressed in terms of current money.

2. What is wrong with stable, predictable, constant inflation?

• Imposes a large tax on liquidity--so you spend too much of your time running from place to place managing your cash flow; degrades the effectiveness of the price system as a resource allocation mechanism; the interaction of the a ystem with inflation penalizes many socially useful economic activities. See Mankiw, pp. 164-165.

3. What is the real interest rate? What is the nominal interest rate? How are they different?

• The nominal interest rate is the coupon on a bond, the discount on a bill, or the contractual payment on a loan: how much its costs in dollars to hire a dollar for a year; the real interest rate is how much it costs in useful commodities to hire a certain amount of purchasing power over goods and services for a year; the difference is the inflation rate: the real interest rate is the nominal interest rate minus inflation.

4. How would you measure the real interest rate?

• A tricky question. To measure the after-the-fact, ex-post real interest rate, start with the nominal interest rate and substract whatever the inflation rate happened to be over the time period. To measure the expected, ex-ante real interest rate you need (somehow) to find good data on what the representative expectations of people in the economy were when they were making their decisions.

5. Suppose that the income velocity of money is increasing at a steady 5% per year, the level of real GDP is increasing at 3% per year, and the money stock is increasing at 2% per year. What is the rate of inflation?

• 5 + 2 - 3 = 4 percent per year is the rate of inflation.

6. Suppose the rate of growth of the money stock jumps to ten percent per year and other variables in the quantity equation remain unchanged. What is the rate of inflation?

• 5 + 10 - 3 = 12 perdent per year is the rate of inflation

7. Explain why a borrower should be more concerned about the real interest rate he or she pays than the nominal interest rate.

• A borrower should be concerned not with how many pictures of George Washington he has to pay back to pay off the loan, but with how much real purchasing power the loan is going to cost--and that is best measured by the real interest rate.

8. Suppose that the government taxes nominal interest payments at 33%. Suppose the expected (and actual) inflation rate rises from zero to ten percent per year. Would you expect the real interest rate to rise or fall as a result of this change in inflation. Why?

• The government taxes away one-third of any inflation premium that gets built into loans' nominal interest rates as a result of the boost to inflation. The Fisher effect would suggest that the nominal interest rate would rise by the amount of the increase in inflation--by ten percentage points per year. But does the pre-tax interest rate the borrower pays rise by ten percent (in which case the after tax interest rate the lender receives rises by less)? Or does the after-tax interest rate the lender receives rise by ten percent (in which case the pre-tax interest rate the borrower pays rises by more)?

The best bet is probably to argue that the burden of the extra tax levied on the inflation-compensation component of the interest rate falls on both borrowers and lenders, so that the interest rate lenders receive rises by less than the change in inflation (so their real interest rate falls) and the interest rate borrowers pay rises by more than the change in inflation (so their interest rate rises).

So the most correct answer is probably "both".

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# Econ 100b

Created 4/30/1996
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