Macroeconomics I ketevani kapanadze
Problem Set 5
Answer the following questions:
1) List and describe six costs of inflation.
Answer: Six costs of inflation are: (1) shoeleather costs; (2) menu costs; (3) relative-price
variability and the misallocation of resources; (4) inflation-induced tax distortions; (5) confusion
and inconvenience; and (6) arbitrary redistributions of wealth. Shoeleather costs arise because
inflation causes people to spend resources going to the bank more often. Menu costs occur when
people spend resources changing their posted prices. Relative-price variability occurs because
as general prices rise, a fixed dollar price translates into a declining relative price, so the relative
prices of goods are constantly changing, causing a misallocation of resources. The combination
of inflation and taxation causes distortions in incentives because people are taxed on their
nominal capital gains and interest income instead of their real income from these sources.
Inflation causes confusion and inconvenience because it reduces money’s ability to function as a
unit of account. Unexpected inflation redistributes wealth between borrowers and lenders.
2) Explain how an increase in the price level affects the real value of money.
Answer: An increase in the price level reduces the real value of money because each dollar in
your wallet now buys a smaller quantity of goods and services.
3) According to the Fisher effect, how does an increase in the inflation rate affect the real interest
rate and the nominal interest rate?
Answer: According to the Fisher effect, an increase in the inflation rate raises the nominal interest
rate by the same amount that the inflation rate increases, with no effect on the real interest rate.
4) Suppose that this year’s money supply is $500 billion, nominal GDP is $10 trillion, and real GDP
is $5 trillion.
Macroeconomics I ketevani kapanadze
a. What is the price level? What is the velocity of money?
Answer: (All amounts in billions) Nominal GDP = P × Y = $10,000 and Y = real GDP = $5,000, so P
= (P × Y )/Y = $10,000/$5,000 = 2.
Because M × V = P × Y, then V = (P × Y )/M = $10,000/$500 = 20.
b. Suppose that velocity is constant and the economy’s output of goods and services rises by 5%
each year. What will happen to nominal GDP and the price level next year if the Fed keeps the
money supply constant?
Answer: If M and V are unchanged and Y rises by 5%, then because M × V = P × Y, P must fall by
5%. As a result, nominal GDP is unchanged.
c. What money supply should the Fed set next year if it wants to keep the price level stable?
Answer: To keep the price level stable, the Fed must increase the money supply by 5%, matching
the increase in real GDP. Then, because velocity is unchanged, the price level will be stable.
d. What money supply should the Fed set next year if it wants inflation of 10%?
Answer: If the Fed wants inflation to be 10%, it will need to increase the money supply 15%. Thus
M × V will rise 15%, causing P × Y to rise 15%, with a 10% increase in prices and a 5% rise in real
GDP.
5) Define the nominal exchange rate and real exchange rate and explain how they are related. If
the nominal exchange rate goes from 100 to 120 yen per dollar, has the dollar appreciated or
depreciated?
Answer: The nominal exchange rate is the rate at which a person can trade the currency of one
country for the currency of another. The real exchange rate is the rate at which a person can
trade the goods and services of one country for the goods and services of another. They are
related through the expression: real exchange rate equals nominal exchange rate times domestic
price divided by foreign price.
Macroeconomics I ketevani kapanadze
If the nominal exchange rate goes from 100 to 120 yen per dollar, the dollar has appreciated
because a dollar now buys more yen.
6) If a Japanese car costs 500,000 yen, a similar American car costs $10,000, and a dollar can buy
100 yen, what are the nominal and real exchange rates?
Answer: If a dollar can buy 100 yen, the nominal exchange rate is 100 yen per dollar. The real
exchange rate equals the nominal exchange rate times the domestic price divided by the foreign
price, which equals 100 yen per dollar times $10,000 per American car divided by 500,000 yen
per Japanese car, which equals two Japanese cars per American car.
7) Describe the difference between foreign direct investment and foreign portfolio investment.
Who is more likely to engage in foreign direct investment—a corporation or an individual
investor? Who is more likely to engage in foreign portfolio investment?
Answer: Foreign direct investment requires actively managing an investment, for example, by
opening a retail store in a foreign country. Foreign portfolio investment is passive, for example,
buying corporate stock in a retail chain in a foreign country. As a result, a corporation is more
likely to engage in foreign direct investment, while an individual investor is more likely to engage
in foreign portfolio investment.