Economics 3307
Sample Answers to End-of-Chapter Study Questions
Mankiw, Chapter 4
CHAPTER 4: p. 109, Questions for Review #7, #10
7. As a long-run matter (and this chapter deals with the long-run), expected inflation equals actual inflation. Thus expected inflation rises from 6 to 8 percent. The real interest rate is determined by real savings and real investment, both of which are unaffected by the higher inflation. Thus the real interest rate is unchanged, and the nominal interest rate increases by 2 percentage points.
10. A real variable is a variable that is measured, in effect, in terms of purchasing power (quantity of goods and services). A nominal variable is measured in terms of currency units such as dollars. Nominal income is the number of dollars a person earns. Real income is the quantity of goods and services he or she can buy with those dollars. If nominal income rises by 5% and prices rise 5%, then real income does not change.
CHAPTER 4: pp. 109-110, Problems and Applications #2, #3, #6
2. MV = PY implies %DM + %DV = %DP + %DY. We are given %DV = 0 as Velocity is constant. %DM = 14 and %DY = 5. Thus 14 + 0 = %DP + 5, which implies %DP = 9. In long-run equilibrium this means that expected inflation is 9%. If the nominal interest rate is 11%, the real interest rate is 11-9 = 2%.
3. a. Social Security benefits are indexed to inflation. That is, they are automatically adjusted upward each year according to the rise in the Consumer Price Index in the previous year.
b. Not really. Higher Cost-of-Living increases in Social Security benefits simply allow retired consumers to keep up with inflation. The lower increase in benefits is matched by a lower increase in cost-of-living. (I assume this question should read “… cost of low inflation …”)
6. If inflation is higher than expected, the realized real interest rate is lower than the expected real interest rate. In this case lenders receive a lower real return than they expected when they made the loan. Suppose people buy government bonds (make loans to the government) for a 6% nominal interest rate, expecting 2% inflation. They therefore expect a 4% real return. If actual inflation is 4% as expected, lenders get the real return of 4% they expected. If actual inflation turns out to be 6%, lenders get a real return of zero. In this case, the government has in some sense “repudiated” its obligation by creating inflation that deprives the lenders of what they expected in good faith. Coolidge would therefore have been more correct had he said “Unanticipated inflation is repudiation.”