## PROBLEMS AND APPLICATIONS

1. What are the three functions of money? Which of the functions do the following items satisfy? Which do they not satisfy?

1. A credit card

2. A painting by Rembrandt

3. A subway token

2. In the country of Wiknam, the velocity of money is constant. Real GDP grows by 5 percent per year, the money stock grows by 14 percent per year, and the nominal interest rate is 11 percent. What is the real interest rate?

3. A newspaper article once reported that the U.S. economy was experiencing a low rate of inflation. It said that “low inflation has a downside: 45 million recipients of Social Security and other benefits will see their checks go up by just 2.8 percent next year.”

1. Why does inflation affect the increase in Social Security and other benefits?

2. Is this effect a cost of inflation, as the article suggests? Why or why not?

4. 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.

1. What is the average inflation rate?

2. How would inflation be different if real income growth were higher? Explain.

3. Suppose that instead of a constant money demand function, the velocity of money in this economy was growing steadily because of financial innovation. How would this situation affect the inflation rate? Explain.

5. Suppose you are advising a small country (such as Bermuda) on whether to print its own money or to use the money of its larger neighbour (such as the United States). What are the costs and benefits of a national money? You could also think of advising a sovereign Quebec, after separation from the rest of Canada. Should a separate Quebec use the Canadian dollar? Should the rest of Canada permit Quebec to use its currency? Does the relative political stability of the two countries have any role in this decision?

6. During World War II, both Germany and England had plans for a paper weapon: they each printed the other’s currency, with the intention of dropping large quantities by airplane. Why might this have been an effective weapon?

7. Suppose that the money demand function takes the form

(M/P)d = L(i, Y) = Y/(5i)

1. If output grows at rate g, at what rate will the demand for real balances grow (assuming constant nominal interest rates)?

2. What is the velocity of money in this economy?

3. If inflation and nominal interest rates are constant, at what rate, if any, will velocity grow?

4. 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?

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8. Calvin Coolidge (U.S. president in the 1920s) once said that “inflation is repudiation.” What might he have meant by this? Do you agree? Why or why not? Does it matter whether the inflation is expected or unexpected?

9. Some economic historians have noted that during the period of the gold standard, gold discoveries were most likely to occur after a long deflation. (The discoveries of 1896 are an example.) Why might this be true?

10. Suppose that consumption depends on the level of real money balances (on the grounds that real money balances are part of wealth). Show that if real money balances depend on the nominal interest rate, then an increase in the rate of money growth affects consumption, investment, and the real interest rate. Does the nominal interest rate adjust more than one-for-one or less than one-for-one to expected inflation?

This deviation from the classical dichotomy and the Fisher effect is called the Mundell–Tobin effect. How might you decide whether the Mundell–Tobin effect is important in practice?

11. Use the Internet to identify a country with high inflation over the past year and another country that has had low inflation. (Hint: One useful website is http://www.economist.com/markets-data) For the two countries, find the rate of money growth and the current level of the nominal interest rate. Relate your findings to the theories presented in this chapter.