Foundations of Economics for International Business Selected Solutions to Homework Assignment 4

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1 Foundations of Economics for International Business Selected Solutions to Homework Assignment 4 INSTRUCTOR: XIN TANG Department of World Economics Economics and Management School Wuhan University Fall 2015 Due at November 26th, 2015 (Thursday) 1 MULTIPLE CHOICES: 60% Instructions: Choose the one alternative that best completes the statement or answers the question. If you think any of the problem is not clear, state specifically with argument on where you think is not clear, explain and justify your answer. 1. When a pizza maker lists the price of a pizza as $10, this is an example of using money as a: (A) store of value. (B) unit of account. (C) medium of exchange. (D) flow of value. 2. If there are 100 transactions in a year and the average value of each transaction is $10, then if there is $200 of money in the economy, transactions velocity is times per year. (A) 0.2 (B) 2 (C) 5 (D) If the average price of goods and services in the economy equals $10 and the quantity of money in the economy equals $200,000, then real balances in the economy equal: 1

2 (A) 10. (B) 20,000. (C) 200,000. (D) 2,000, If the demand for real money balances is proportional to real income, velocity will: (A) increase as income increases. (B) increase as income decreases. (C) vary directly with the interest rate. (D) remain constant. 5. Consider the money demand function that takes the form (M/P) d = ky, where M is the quantity of money, P is the price level, and Y is real output. If the money supply is growing at a 10 percent rate, real output is growing at a 3 percent rate, and k is constant, what is the rate of inflation in this country? (A) 3 percent (B) 7 percent (C) 10 percent (D) 13 percent 6. According to the quantity theory of money, if money is growing at a 10 percent rate and real output is growing at a 3 percent rate, but velocity is growing at increasingly faster rates over time as a result of financial innovation, the rate of inflation must be: (A) increasing. (B) decreasing. (C) 7 percent. (D) constant. 7. Percentage change in P is approximately equal to the percentage change in: (A) M. (B) M minus percentage change in Y. (C) M minus percentage change in Y plus percentage change in velocity. (D) M minus percentage change in Y minus percentage change in velocity. 8. The ex ante real interest rate is equal to the nominal interest rate: (A) minus the inflation rate. 2

3 (B) plus the inflation rate. (C) minus the expected inflation rate. (D) plus the expected inflation rate. 9. Equilibrium in the market for goods and services determines the interest rate and the expected rate of inflation determines the interest rate. (A) ex ante real; ex ante nominal (B) ex post real; ex post nominal (C) ex ante nominal; ex post real (D) ex post nominal; ex post real 10. If the real return on government bonds is 3 percent and the expected rate of inflation is 4 percent, then the cost of holding money is percent. (A) 1 (B) 3 (C) 4 (D) If inflation is 6 percent and a worker receives a 4 percent wage increase, then the worker s real wage: (A) increased 4 percent. (B) increased 2 percent. (C) decreased 2 percent. (D) decreased 6 percent. 12. The unemployment insurance system may be desirable because unemployment insurance: (A) raises the natural rate of unemployment. (B) reduces the rate of job finding. (C) increases workers uncertainty about their incomes. (D) induces workers to reject unattractive job offers. 2 NUMERICAL AND SHORT ANSWER PROBLEMS: 40% Remember you have to show the detailed calculation, reason, induction or any other necessary process of your solution. 3

4 1. (20%) Suppose a country has a money demand function (M/P) d = ky, where k is a constant parameter. The money supply grows by 12 percent per year and real income grows by 4 percent per year. (a) What is the average inflation rate? (6%) (b) How would inflation be different if real income growth were higher? Explain. (6%) (c) Suppose, instead of a constant money demand function, the velocity of money in this economy was growing steadily because of financial innovation. How would that affect the inflation rate? Explain. (8%) 2. (20%) Suppose that the money demand function takes the form M d = L(i,Y ) = Y P 5i (a) If output grows at rate g, at what rate will the demand for real balances grow (assuming constant nominal interest rates)? (4%) (b) What is the velocity in this economy? (4%) (c) If inflation and nominal interest rates are constant, at what rate, if any, will velocity grow? (6%) (d) How will a permanent (once and for all) increase in the level of interest rates affect the level of velocity? How will it affect the subsequent growth rate of velocity? (6%) 3 SOLUTIONS Multiple Choices: 1 5 B C B D B; 6 10 A C C A D; C D Numerical: 1. (a) To find the average inflation rate the money demand function can be expressed in terms of growth rates: % growth M d % growth P = % growth Y The parameter k is a constant, so it can be ignored. The percentage change in nominal money demand Md is the same as the growth in the money supply because nominal money demand has to equal nominal money supply. If nominal money demand grows 12 percent and real income (Y ) grows 4 percent then the growth of the price level is 8 percent. 4

5 (b) From the answer to part (a), it follows that an increase in real income growth will result in a lower average inflation rate. For example, if real income grows at 6 percent and money supply growth remains at 12 percent, then inflation falls to 6 percent. In this case, a larger money supply is required to support a higher level of GDP, resulting in lower inflation. (c) If velocity growth is positive, then all else the same inflation will be higher. From the quantity equation we know that: % growth M + % growth V = % growth P + % growth Y. Suppose that the money supply grows by 12 percent and real income grows by 4 percent. When velocity growth is zero, inflation is 8 percent. Suppose now that velocity grows 2 percent: this will cause prices to grow by 10 percent. Inflation increases because the same quantity of money is being used more often to chase the same amount of goods. In this case, the money supply should grow more slowly to compensate for the positive growth in velocity. 2. (a) If output Y grows at rate g, then real money balances (M/P) d must also grow at rate g, given that the nominal interest rate i is a constant. (b) To find the velocity of money, start with the quantity equation MV = PY and rewrite the equation as V = (PY )/M = (P/M )Y. Now, note that P/M is the inverse of the real money supply, which is equal to real money demand. Therefore, the velocity of money is V = (5i/Y ) Y, or V = 5i. (c) If the nominal interest rate is constant, then the velocity of money must be constant. (d) A one-time increase in the nominal interest rate will cause a one-time increase in the velocity of money. There will be no further changes in the velocity of money. 5