P-Set Three Answers
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
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
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
- 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".