Tackle the Test: Free-Response Questions

1. Question

   In the following examples: (i) indicate whether inflation imposes a net cost on the economy; (ii) explain your answer; and (iii) identify the type of net cost involved if there is one.

   
   

   
   

   1. When inflation is expected to be high, workers get paid more frequently and make more trips to the bank.

      
      
   
   

   2. Lanwei is reimbursed by her company for her work-related travel expenses. Sometimes, however, the company takes a long time to reimburse her. So when inflation is high, she is less willing to travel for her job.

      
      
   
   

   3. Hector Homeowner has a mortgage loan that he took out five years ago with a fixed 6% nominal interest rate. Over the years, the inflation rate has crept up unexpectedly to its present level of 7%.

      
      
   
   

   4. In response to unexpectedly high inflation, the manager of Cozy Cottages of Cape Cod must reprint and resend expensive color brochures correcting the price of rentals this season.

      
      
   
   

   Rubric for FRQ 1 (11 points)

   1 point: There is a net cost to the economy.

   1 point: There is an increase in the cost of financial transactions imposed by inflation.

   1 point: This type of cost is called a shoe-leather cost.

   1 point: There is a net cost to the economy.

   1 point: Lanwei’s forgone output is a cost to the economy.

   1 point: This type of cost is called a unit-of-account cost.

   1 point: There is no net cost to the economy.

   1 point: Hector gains and the bank loses because the money Hector pays back is worth less than expected.

   1 point: There is a net cost to the economy.

   1 point: Cozy Cottages must reprint and resend the expensive brochure when inflation causes rental prices to rise.

   1 point: This type of cost is called a menu cost.

2. Question

   You borrow $1,000 for one year at 5% interest to buy a couch. Although you did not anticipate any inflation, there is unexpected inflation of 5% over the life of your loan.

   
   

   
   

   1. What was the real interest rate on your loan?

      
      
   
   

   2. Explain how you gained from the inflation.

      
      
   
   

   3. Who lost as a result of the situation described? Explain.(4 points)

      
      
   
   

   Rubric for FRQ 2 (4 points)

   1 point: 0%

   1 point: You borrowed enough money to buy a couch and paid back just enough to buy the same couch (after inflation). Therefore, you gained the benefit of the loan (having the couch for 1 year) without paying any real interest for it.

   1 point: The lender lost.

   1 point: The loan was paid back after prices unexpectedly increased, so the lender received a real interest rate of 0% for allowing you to use the money for a year.