BUSI 101 - Chapter 11

(a)3 What is hyperinflation?

(a)4 Why is inflation not inevitable in an economy?

(a)5 What central question does the quantity theory of money attempt to answer?

(a)3 An extraordinarily high rate of inflation. The chapter later gives a conventional definition of inflation exceeding 50 percent per month.

(a)4 Historical periods have experienced stable or falling prices, showing that persistent increases in the price level are not unavoidable.

(a)5 It explains what determines the long-run price level and inflation rate, particularly the relationship between growth in the money supply and inflation.

(b)1 What is the first key insight about inflation regarding the value of money?

(b)3 If P represents the price level, what does 1/P represent?

(b)5 Why is inflation fundamentally an economy-wide monetary phenomenon rather than simply the result of a few individual prices increasing?

(b)1 Inflation is primarily about a decline in the value of money rather than an increase in the underlying value of every good.

(b)3 The quantity of goods and services that can be purchased with one dollar—the value of money.

(b)5 Inflation concerns a sustained rise in the overall price level and therefore a decline in the purchasing power of the economy’s medium of exchange, not merely changes in individual relative prices.

(c)1 What determines the value of money according to the quantity theory?

(c)2 What determines the supply of money in the simplified model used in this chapter?

(c)3 What is money demand?

(c)4 Why is the demand for money sometimes called liquidity preference?

(c)5 What important factors can affect how much money people want to hold?

(c)1 The supply and demand for money.

(c)2 The Bank of Canada, treated in this chapter as controlling the quantity of money supplied.

(c)3 The amount of wealth people choose to hold in liquid monetary form.

(c)4 Money is the most liquid asset, so demanding money means preferring to hold some wealth in liquid form.

(c)5 The price level, interest rates, use of credit cards, access to ATMs, and other factors affecting the convenience and opportunity cost of holding money.

(d)2 In the long run, what variable adjusts to bring money supply and money demand into equilibrium?

(d)3 What happens if the price level is above its long-run equilibrium level?

(d)4 What happens if the price level is below its long-run equilibrium level?

(d)5 What condition defines monetary equilibrium?

(d)2 The overall price level.

(d)3 People want to hold more money than exists, so the price level falls until demand equals supply.

(d)4 People hold more money than they want, so spending increases and the price level rises.

(d)5 Quantity of money demanded equals quantity of money supplied.

(e)1 Why is the money-supply curve vertical in the long-run money-market model?

(e)2 Why does the money-demand curve slope downward when the vertical axis measures the value of money?

(e)3 Why is the price-level axis in the money-market diagram inverted relative to the value-of-money axis?

(e)1 The model treats the Bank of Canada as fixing the quantity of money independently of its value.

(e)2 A lower value of money corresponds to a higher price level, requiring people to hold more money to conduct transactions.

(e)3 The value of money and price level move inversely: 1/P falls when P rises.

(f)1 What is the quantity theory of money?

(f)3 How does an increase in the money supply create an initial excess supply of money?

(f)4 How do households attempt to reduce their excess money holdings after a monetary injection?

(f)5 Why does greater spending after a monetary injection eventually lead to a higher price level?

(f)1 The theory that the quantity of money determines the value of money and that growth in money is the primary long-run cause of inflation.

(f)3 People initially hold more money than they desire at the existing price level.

(f)4 They spend it on goods and services, buy bonds, or deposit it in financial institutions, allowing others to spend it.

(f)5 Spending rises while the economy’s long-run productive capacity has not increased, putting upward pressure on the overall price level.

(g)1 Why does a monetary injection not automatically increase the economy’s long-run productive capacity?

(g)2 What determines the economy’s long-run production of goods and services?

(g)3 How does a rising price level help restore equilibrium in the money market after a monetary injection?

(g)1 Money creation does not create additional labour, capital, natural resources, human capital, or technological knowledge.

(g)2 Labour, physical capital, human capital, natural resources, and available technology.

(g)3 Higher prices increase the dollar amount people need to hold for transactions, raising money demand until it equals the new money supply.

(h)1 What is the classical dichotomy?

(h)2 What is the difference between nominal and real variables?

(h)3 Give examples of nominal economic variables.

(h)4 Give examples of real economic variables.

(h)5 Why are ordinary dollar prices nominal variables while relative prices are real variables?

(h)1 The division of economic variables into nominal variables and real variables.

(h)2 Nominal variables are measured in monetary units; real variables are measured in physical quantities or relative terms.

(h)3 The dollar wage, nominal GDP, and dollar prices of goods.

(h)4 Real GDP, quantities of output, employment, real wages, and real interest rates.

(h)5 When two dollar prices are compared, the monetary units cancel, leaving a ratio measured in physical terms.

(i)1 Why is the real wage considered a real variable?

(i)2 Why is the real interest rate considered a real variable?

(i)1 It measures the quantity of goods and services that can be exchanged for a unit of labour rather than merely the number of dollars paid.

(i)2 It measures the rate at which present goods and services are exchanged for future goods and services.

(j)4 Why is monetary neutrality considered a better description of the long run than the short run?

(j)5 Over what kind of time horizon do economists generally believe monetary changes can affect real variables?

(j)4 Prices and contracts may adjust slowly, so monetary changes can temporarily influence production and employment.

(j)5 Over short periods such as a year or two.

(k)1 What is the velocity of money?

(k)2 How is the velocity of money calculated?

(k)3 What does a velocity of 20 mean?

(k)4 Write the quantity equation.

(k)5 What does the quantity equation describe?

(k)1 The rate at which the typical unit of money changes hands in transactions involving newly produced goods and services.

(k)2 V=PY/M, or nominal GDP divided by the quantity of money.

(k)3 Each dollar is used, on average, about 20 times during the year to purchase newly produced goods and services.

(k)4 MV=PY.

(k)5 It relates the quantity of money and its velocity to the nominal value of economic output.

(m)1 What are the five main steps underlying the quantity theory’s explanation of inflation?

(m)4 Why does rapid money growth generate rapid inflation under the quantity theory?

(m)5 Why are hyperinflations especially useful for studying the relationship between money and prices?

(m)1 Velocity is relatively stable; money growth therefore changes nominal GDP proportionately; real output is determined by real factors; money is neutral in the long run; therefore changes in nominal GDP caused by money growth show up mainly in the price level.

(m)4 With velocity stable and real output determined independently, the nominal increase caused by more money must largely become higher prices.

(m)5 The enormous movements in both money and prices make the underlying long-run relationship easier to observe.

(n)4 What do the experiences of Austria, Hungary, Germany, and Poland illustrate about the quantity theory?

(n)5 What broader political and social consequences can hyperinflation create beyond rapidly rising prices?

(n)4 They show nearly parallel movements in the quantity of money and the price level during hyperinflations.

(n)5 Economic impoverishment, political instability, coups, corruption, and other severe social consequences can follow.

(o)1 What is the inflation tax?

(o)2 How does a government obtain real resources by printing money?

(o)3 Why is the inflation tax economically similar to a tax on people who hold money?

(o)4 Under what fiscal circumstances are governments most likely to rely heavily on money creation?

(o)5 Why is the inflation tax currently a relatively unimportant source of revenue in Canada?

(o)1 Revenue obtained by government through creating money and causing inflation.

(o)2 Newly created money is used to purchase goods and services or finance government expenditures.

(o)3 Inflation reduces the purchasing power of existing money balances, transferring purchasing power from money holders toward the issuer of new money.

(o)4 When spending is high, tax revenue is inadequate, and borrowing opportunities are limited.

(o)5 The chapter states that it accounts for less than 1 percent of Canadian government revenue.

(p)4 How did Zimbabwe eventually end its hyperinflation?

(p)4 The central bank stopped printing the Zimbabwe dollar and the country shifted toward foreign currencies such as the U.S. dollar and South African rand.

(q)2 What determines the real interest rate in the long run?

(q)3 What determines the inflation rate according to the quantity theory?

(q)4 What is the Fisher effect?

(q)5 Why should a higher long-run inflation rate lead to a roughly equal increase in the nominal interest rate?

(q)2 Supply and demand for loanable funds.

(q)3 Money-supply growth in the long run.

(q)4 The tendency of the nominal interest rate to adjust one-for-one with expected inflation in the long run.

(q)5 Monetary neutrality means the real interest rate remains unchanged, so higher inflation must be reflected in the nominal rate.

(s)1 What is the “inflation fallacy”?

(s)2 Why does inflation not automatically reduce everyone’s real purchasing power?

(s)4 Why are real incomes determined by real economic factors rather than simply by the inflation rate?

(s)1 The mistaken belief that inflation necessarily lowers everyone’s purchasing power simply because prices rise.

(s)2 Prices are also incomes to sellers, and wages and other nominal incomes generally rise along with the overall price level.

(s)4 Real incomes depend on productivity, capital, natural resources, human capital, and technology.

(t)1 If inflation does not automatically reduce real purchasing power, why can inflation still impose economic costs?

(t)2 What are shoeleather costs?

(t)3 Why does inflation encourage people to hold smaller money balances?

(t)4 Why are shoeleather costs usually small under moderate inflation but potentially large under hyperinflation?

(t)5 How did the Bolivian hyperinflation example illustrate shoeleather costs?

(t)1 Inflation changes incentives, creates transaction and adjustment costs, distorts taxes and relative prices, and can redistribute wealth.

(t)2 The costs people incur from reducing their holdings of money to avoid the inflation tax.

(t)3 Inflation erodes the real value of non-interest-bearing money balances.

(t)4 Under very high inflation, money loses value rapidly, forcing people to spend substantial time and effort managing cash balances.

(t)5 People had to convert local currency into goods or foreign currency almost immediately after receiving income to avoid rapid losses in purchasing power.

(u)1 What are menu costs?

(u)2 What types of expenses are included in menu costs?

(u)5 Why do firms often leave prices unchanged for periods of time even when economic conditions change?

(u)1 The costs firms incur when changing their prices.

(u)2 Deciding on new prices, printing catalogues or menus, informing customers, advertising changes, and handling customer reactions.

(u)5 Changing prices itself is costly.

(v)1 How does inflation increase relative-price variability?

(v)2 Why would a restaurant that changes prices only once per year experience changing relative prices during inflation?

(v)3 Why are relative prices important in a market economy?

(v)4 How can inflation-induced relative-price distortions lead to a misallocation of resources?

(v)5 Why is relative-price variability greater when inflation is higher?

(v)1 Because firms adjust prices at different times, inflation causes their relative prices to rise and fall between adjustments.

(v)2 Its nominal prices remain fixed while the general price level rises, causing its prices relative to other goods to decline over time.

(v)3 Relative prices guide consumer choices and the allocation of scarce factors of production.

(v)4 Distorted relative prices can cause consumers and firms to make decisions based on misleading price signals.

(v)5 Faster increases in the general price level create larger relative-price movements between price adjustments.

(x)2 Why can inflation-induced taxation reduce national saving?

(x)4 What is tax indexation?

(x)2 It reduces the after-tax real return to saving.

(x)4 Adjusting tax provisions so tax liabilities are based on real rather than inflation-distorted nominal values.

(y)3 How does inflation create confusion by changing the value of the economy’s unit of account?

(y)4 Why can inflation make accounting profits harder to interpret?

(y)5 How can inflation-induced accounting confusion interfere with financial markets’ allocation of saving?

(y)3 Dollars from different time periods no longer represent the same purchasing power, making economic measurement less reliable.

(y)4 Revenues and costs may be measured in dollars of different real values, distorting measured earnings.

(y)5 Investors may have greater difficulty distinguishing profitable firms from unprofitable ones, reducing the efficiency of capital allocation.

(aa)4 What relationship does the chapter identify between the average rate of inflation and the volatility of inflation?

(aa)5 Why does high and unstable inflation create additional economic risk?

(aa)4 Higher average inflation tends to be associated with greater inflation volatility.

(aa)5 It makes real returns and real debt burdens more uncertain, increasing risk for borrowers and lenders.

(ab)1 What is the Friedman rule?

(ab)2 Why did Milton Friedman argue that a small amount of deflation might be desirable?

(ab)4 What costs of deflation resemble the costs of inflation?

(ab)1 The proposal that monetary policy should produce enough deflation to drive the nominal interest rate toward zero.

(ab)2 A zero nominal interest rate minimizes the opportunity cost of holding money and therefore minimizes shoeleather costs.

(ab)4 Menu costs and relative-price variability occur with both rising and falling prices.

(ac)3 Why might deflation therefore be worse than moderate inflation in practice?

(ac)5 What was the Bank of Canada’s policy of monetary gradualism

(ac)3 It can accompany falling production and increasing unemployment in addition to imposing its own price-adjustment and debt-redistribution costs.

(ac)5 A policy of gradually reducing the target growth rate of M1 in an attempt to gradually reduce inflation.

(ad)1 Why did the Bank of Canada eventually abandon monetary gradualism?

(ad)2 What did Gerald Bouey mean by the statement “We did not abandon M1. M1 abandoned us”?

(ad)3 Why can the relationship between money growth and inflation be weak within one country over short periods?

(ad)4 Why is the relationship between money growth and inflation clearer across countries or over long periods?

(ad)5 What role does variation in velocity play in weakening the short-run money-growth/inflation relationship?

(ad)1 Inflation did not respond predictably enough to changes in M1 growth.

(ad)2 The relationship between measured M1 growth and inflation became too unstable for M1 to serve as a reliable policy target.

(ad)3 Short-run variations in velocity and other economic conditions can be large relative to movements in money growth.

(ad)4 Over longer periods and across countries, differences in money growth are much larger relative to changes in velocity.

(ad)5 Changes in velocity alter nominal spending independently of money growth, weakening the short-run relationship.

(ae)1 What monetary-policy framework has the Bank of Canada used since 1992?

(ae)5 What policy instrument does the Bank use to keep inflation near its target?

(ae)1 Inflation targeting.

(ae)5 The overnight rate.

(af)1 Why can money growth and inflation appear weakly correlated under a successful inflation-targeting regime?

(af)2 How does Milton Friedman’s thermostat analogy explain this weak observed relationship?

(af)3 In the thermostat analogy, what corresponds to the outside temperature?

(af)4 In the thermostat analogy, what corresponds to the amount of gas burned by the furnace?

(af)5 What corresponds to the temperature inside the house?

(af)1 The central bank changes money growth precisely to offset changes in other factors affecting inflation.

(af)2 A thermostat adjusts furnace activity whenever external conditions change, keeping room temperature stable. Similarly, the central bank adjusts monetary policy to offset changes in velocity and keep inflation stable.

(af)3 Changes in velocity and other economic conditions.

(af)4 Money growth or monetary-policy adjustments.

(af)5 Inflation.

(ag)1 Why does a weak observed correlation between money growth and inflation not disprove the quantity theory?

(ag)1 Policy itself responds to forces that would otherwise change inflation, masking the underlying causal relationship in observed data.

(ah)1 What kinds of components are excluded from the Bank’s core inflation measure described in the chapter?

(ah)2 Why are changes in indirect taxes excluded from the core inflation measure?

(ah)1 The most volatile CPI components and the effects of changes in government indirect taxes.

(ah)2 Tax changes can temporarily alter consumer prices without reflecting underlying inflationary pressure.

(ai)1 What is the chapter’s overall explanation for sustained inflation?

(ai)4 What is the chapter’s overall conclusion about why moderate inflation can still be costly?

(ai)5 What is the chapter’s overall lesson about the role of the Bank of Canada in maintaining price stability?

(ai)1 Sustained inflation ultimately results from sustained growth in the money supply relative to the economy’s real productive capacity.

(ai)4 Even predictable inflation creates shoeleather costs, menu costs, relative-price distortions, tax distortions, and confusion; unexpected inflation also redistributes wealth.

(ai)5 The Bank of Canada uses monetary policy, particularly the overnight rate, to keep inflation close to its target and maintain confidence in the value of money.