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Solutions to Tutorial Questions

(Any discrepancies must be discussed with lecturer)

Tutorial week 2
Chapter 5
Review questions
1 An economys income must equal its expenditure since every transaction has a buyer and a
seller. Expenditure by buyers equals income by sellers.
2 Whether the production of a tonne of wheat or the production of a tonne of coal contributes more
to GDP depends on which product has a higher market value. The product with a higher market
value per tonne contributes more to GDP.
3 The contribution to GDP is $5, the market value of the bread, which is the final good that is sold.
4 The sale of used clothes doesnt affect GDP at all because it involves no current production.
5 The four components of GDP are consumption (such as the purchase of a music CD), investment
(such as the purchase of a computer by a business), government purchases (such as the purchase
of military aircraft) and net exports (such as the sale of Australian wine to Britain less the import
of French champagne to Australia).

Problems

1 a Household expenditure increases, i.e. consumption increases.


b New housing is part of investment, hence investment increases.
c A new car is part of consumption, hence consumption increases, while investment decreases
since inventories decrease.
d Household expenditure and hence consumption increases.
e A new bike path is part of government expenditure (public good), hence government
purchases increase.
f Wine is a consumption good, hence consumption increases. However, since the wine was
imported, net exports (exports imports) decrease.
g A new factory represents an increase in investment expenditure.
6 Year Nominal GDP (in millions) GDP deflator (base year 200708)
2009 $1,250,474 102.9
2010 $1,301,551 109.6
a The growth rate of nominal income is ($1,301,551 $1,250,474) / $1,250,474 x 100 per
cent = 4.08 per cent.
b The growth rate of the deflator is (109.6 102.9) / 102.9 x 100 per cent = 6.51 per cent.
c Real income in 2009 measured in 2008 prices is $1,250,474 / (102.9/100) = $1,215,232.
d Real income in 2010 measured in 2008 prices is $1,301,551 / (109.6 / 100) = $1,187,547.
e The growth rate of real income is ($1,187,547 $1,215,232) / $1,215,232 x 100 per cent
= 2.28 per cent.
f The growth rate of nominal income is higher than the growth rate of real income because of
inflation.
7 Since the impact of rising prices is removed when reporting real GDP, economists prefer to look
at real GDP instead of nominal GDP as a measure of economic wellbeing. Higher prices means
nominal GDP and peoples incomes will increase. However, it does not mean that the quantity of
goods and services has increased or that people are able to purchase more goods and services.
9 To tell if the farmer is better off, youd need to know if the prices of the goods she buys have
increased by more or by less than the prices of the goods she sells.
Chapter 6

Review questions

1 A 10 per cent increase in the price of petrol has a greater effect on the consumer price index than
a 10 per cent increase in the price of iPods because petrol is a bigger part of the average
consumers market basket.
2 The three problems in the consumer price index as a measure of the cost of living are:
(1) substitution bias, which arises because people substitute toward goods that have become
relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in
the CPI; and (3) unmeasured quality change.
3 If the price of a Royal Australian Air Force fighter jet rises, there is no effect on the consumer
price index, since Royal Australian Air Force fighter jets arent consumer goods. But the GDP
deflator is affected, since Royal Australian Air Force fighter jets are included in GDP. The GDP
deflator reflects the price of all goods and services produced domestically.
Problems

1 a The price of tennis balls increases 20 per cent [= ($12 $10) / $10 x 100 per cent]; the price
of tennis racquets increases 12 per cent [= ($140 $125) / $125 x 100 per cent]; the price of
Gatorade increases 11.11 per cent [= ($5 $4.50) / $4.50 x 100 per cent].
To find the percentage change in the overall price level, follow these steps:
i Determine the fixed basket of goods: 100 balls, 10 racquets, 200 Gatorades.
ii Find the price of each good in each year:
Year Tennis balls Tennis racquets Gatorade
2014 $10 $125 $4.50
2015 $12 $140 $5
iii Compute the cost of the basket of goods in each year:
2014: (100 x $10) + (10 x $125) + (200 x $4.50) = $3150
2015: (100 x $12) + (10 x $140) + (200 x $5) = $3600
iv Choose one year as a base year (2014) and compute the CPI in each year:
2014: $3150 / $3150 x 100 = 100
2015: $3600 / $3150 x 100 = 114.29
v Use the CPI to compute the inflation rate from the previous year:
114.29 100 / 100 x 100 per cent = 14.29 per cent
b Tennis racquets are more expensive relative to Gatorade, since their price rose 12 per cent
while the price of Gatorade rose 11.11 per cent. The wellbeing of some people changes
relative to the wellbeing of others. Those who purchase a lot of tennis balls become worse off
relative to those who purchase a lot of Gatorade and tennis racquets.
5 a introduction of new goods
b unmeasured quality change
c substitution bias
d unmeasured quality change
e substitution bias
6 a ($2 $0.05) / $0.05 x 100 = 3900 per cent.
b ($42.10 $3.35) / $3.35 x 100 = 1156.72 per cent.
c In 1970: $0.05 / ($3.35/60) = 0.9 minutes. In 2013: $2 / ($42.1/60) = 2.85 minutes.
d Workers purchasing power fell in terms of newspapers.Note the wage estimates set out in
the text are incorrect and reflect the wage rates that applied in the US.
10 Bracket creep occurs when inflation increases peoples nominal incomes, pushing them into
higher tax brackets, so they have to pay a higher proportion of their incomes in taxes, even
though they arent getting higher real incomes. As a result, real tax revenue rises.
Tutorial week 3:

Review questions

1 GDP measures an economys total production, total income and its total expenditures on goods
and services. This tells us that a societys standard of living depends on its productivity.
2 The four determinants of productivity are: (1) physical capital, which is the stock of equipment
and structures that are used to produce goods and services; (2) human capital, which consists of
the knowledge and skills that workers acquire through education, training and experience; (3)
natural resources, which are inputs into production that are provided by nature; and (4)
technological knowledge, which is the understanding of the best ways to produce goods and
services.
3 A university degree is a form of capital human capital, to be precise. The skills learned in
gaining a university degree increase a workers productivity.
4 Higher saving means fewer resources are devoted to consumption and more to producing capital
goods. The rise in the capital stock leads to rising productivity and more rapid growth in GDP for
a while. In the long run, the higher saving rate leads to a higher standard of living. A policymaker
might be deterred from trying to raise the rate of saving because doing so requires that people
reduce their consumption today and it can take a long time to get to a higher standard of living.
5 A higher rate of saving leads to a higher growth rate temporarily, not permanently. In the short
run, increased saving leads to a larger capital stock and faster growth. But as growth continues,
diminishing returns to capital mean growth slows down and eventually settles down to its initial
rate, though this may take several decades.
6 Holding other factors constant, sufficient nutrient intake improves the work effort workers could
put forth. Better nutrition results in higher productivity and higher productivity contributes to
higher GDP growth rate.
7 Increasing the rate of immigration, assuming the migrants are in the workforce, can help to
increase the level of GDP per person, because there would be a bigger workforce and any skill
shortages could be alleviated.
8 The Australian government tries to encourage advances in technological knowledge via its direct
funding of the Commonwealth Scientific and Industrial Research Organisation (CSIRO), by
providing research grants through the Australian Research Council and the National Health and
Medical Research Council, with tax breaks for firms engaging in research and development and
through the patent system.
Problems:

1 The fact that countries import many goods and services yet must produce a large quantity of
goods and services themselves to enjoy a high standard of living are reconciled by noting that
there are substantial gains from trade. By producing many goods and services, then trading them
for goods and services produced in other countries, a nation maximises its consumption
possibilities and hence its standard of living.
2 a More investment would lead to faster economic growth in the short run.
b To be beneficial to future generations the investment should be in capital goods that increase
the productive capacity of the economy.
c The change would benefit many people in society who would have higher incomes as the
result of faster economic growth. However, there might be a transition period in which
workers and owners in consumption-goods industries would get lower incomes and workers
and owners in investment-goods industries would get higher incomes.
d Saving more now also means consuming less now, so even though the increased saving will
lead to long-term benefits it may not enhance the politicians chances of re-election.
3 Todays standard of living differs from those of our great-grandparents because of improved
transportation, communications, entertainment, machinery for household work and computers,
among other things. Whether the standard of living is higher in every regard depends on an
individual how relaxed or stressed one feels with daily life.
4 In the manufacturing as well as in the agricultural sector, employment relative to output has
fallen sharply. However, output remains about the same percentage of GDP as before. The
change could be regarded as a success for our economy because it is the result of increased
productivity.
5 a Government policy that encourages research through the patent system enhances the incentive
for individuals and firms to encourage in research. The patent gives the inventor a property
right over the invention, turning the new idea from a public good into a private good.
Government policies that fund research in universities through grants from the Australian
Research Council and the National Health and Medical Research Council aid research and
development efforts. Firms engaging in research and development receive tax breaks.
b The government can undertake the investment in R&D, given that knowledge, to a large
extent, is a public good. Business investment in R&D requires the government to encourage
research and development efforts. By allowing private inventors to profit from their
inventions through the patent system, it provides the incentive for private individuals and
firms to engage in research
c The GDP share of business R&D expenditure for Australia is less than that of Sweden,
Finland, Japan and Korea. Other things equal, GDP growth rate in Australia is expected to be
less than the growth rates in Sweden, Finland, Japan and Korea because proportionately fewer
resources in Australia, as measured by GDP share of business R&D expenditure, are allocated
to technological advancement that can raise living standards.
6 The opportunity cost of investing in capital is the loss of consumption that results from
redirecting resources towards investment. A country can over-invest in capital if people would
prefer to have higher consumption spending and less future growth. The opportunity cost of
investing in human capital is also the loss of consumption that is needed to provide the resources
for investment. A country could over-invest in human capital if people were too highly
educated for the jobs they could get for example, if the best job a PhD in philosophy could find
is managing a restaurant. A country needs a diverse workforce, one that provides a range of
skills.
7 a When a German firm opens a factory in China, it represents foreign direct investment.
b The investment increases Chinese GDP since it increases production in China. The effect on
Chinese GNP would be smaller since the owners would get paid a return on their investment
that would be part of German GNP rather than Chinese GNP.
c The destruction of productive resources would limit productive capacity and hence output in
the immediate term. In the following years, investment, both foreign and local, in the form of
new productive resources, should increase, thus increasing Chinese GDP.
9 Restricting the educational opportunities for women, the Afghan provinces are limiting their
opportunities to increase their rate of growth. Increasing the education of the workforce, both
male and female, increases the stock of human capital and hence productivity.
11 a Political stability can lead to strong economic growth by making the country attractive to
investors. The increased investment would raise economic growth.
b Strong economic growth can lead to political stability because when people have high
incomes they tend to be satisfied with the political system and are less likely to overthrow or
change the government.
Tutorial week 4

Review questions

1 The financial systems role is to help match one persons saving with another persons
investment. Two markets that are part of the financial system are: the bond market, through
which large corporations, the federal government, or state and local governments borrow; and the
stock market, through which corporations sell ownership shares. Two financial intermediaries are
banks, which take in deposits and use the deposits to make loans, and managed funds, which sell
shares to the public and use the proceeds to buy a portfolio of financial assets.
2 National saving is the amount of a nations income that isnt spent on consumption or
government purchases. Private saving is the amount of income that households have left after
paying their taxes and paying for their consumption. Public saving is the amount of tax revenue
that the government has left after paying for its spending. The three variables are related because
national saving equals private saving plus public saving.
3 Investment refers to the purchase of new capital, such as equipment or buildings that are used to
produce other goods. It is equal to national saving by an accounting identity.
I = Y C G and S = Y C G, hence I = S.
4 A change in the tax laws that might increase private saving is the introduction of a consumption
tax to replace the income tax. Since a consumption tax wouldnt tax the returns to saving, it
would increase the supply of loanable funds, thus lowering interest rates and increasing
investment.
5 A government budget surplus arises when the government spends less than it receives in tax
revenue. Since a government budget surplus increases national saving, it lowers interest rates
which encourages private investment and thus improves economic growth. A budget deficit
reduces national saving, raises interest rates, crowds out private investment and thus reduces
economic growth.
6 An increase in demand for loanable funds will shift out the demand curve and with no change in
supply, increase the equilibrium interest rate and quantity of loanable funds. The increase in the
quantity is less than the initial increase in demand as the higher interest rate discourages some
investors.

Problems:

1 a The bond of an African government would pay a higher interest rate than the bond of the
Australian government because there would be a greater risk of default.
b A bond that repays the principal in 2030 would pay a higher interest rate than a bond that
repays the principal in 2020 because it has a longer term to maturity, so there is more risk to
the principal.
c A bond from a software company you run in your garage would pay a higher interest rate than
a bond from Microsoft because your software company has more credit risk.
d A bond issued by the federal government may pay a lower interest rate than a bond issued to
finance the construction of a new airport in Brisbane because the new airport in Brisbane
could have marginally higher credit risk.
2 a You would expect the yield curve to be upward sloping because theres more risk on longer
term bonds.
b Generally, the curve you draw will be upward sloping, except in times of monetary tightening
or early in a recession.
c Factors that affect the slope of the yield curve include the length of the time bonds are held
and the rate of interest paid.
3 a Many answers possible but should be focused on key concepts such as risk and return.
b The share market
m does have an elemeent of luck but it also hass an element of wise deciisions
bbased on ressearch. Gettin ng a good retturn on your investment will w reflect th the soundness of the
company in which you in nvested.
c It is a good idea i to hold a portfolio off shares to sp pread risk annd to vary thee length of time any
investment isi held.
4 Durring the Globbal Financiall Crisis, suppply of global loanable fun nds decreaseed shifting su upply to
the left. It resultted in higherr global interrest rate as shhown in Figu ure 8.1 (see bbelow). This higher
inteerest rate led to higher bo orrowing cosst. When Ausstralian bank ks had to borrrow from thee global
finaancial markeets, the high borrowing
b coost in the glo
obal financiall markets ressulted in high her home
loann rates over anda above th he increases iin the cash raate announceed by the Resserve Bank of o
Ausstralia.
5 Shaare markets all a over the world
w move ttogether refleecting the intterconnecteddness in global
finaancial markeets and show how closelyy connected international fund flows aare. Share prrices are
viewwed as harbiingers of futu ure movemennts in real GD DP. As sharee markets inccrease, peoplle
foreesee higher output
o and hiigher corporaate profits an nd hence high her growth leevels and vicce versa.
9 Invvesting in com mpanies with h a low pricee-earnings rattio means thaat shares are purchased when w the
commpany is not performing strongly andd profits are low. l Howeveer, if the com mpany has go ood
proospects, futurre earnings an nd hence thee price-earnin ngs ratio wou uld be expectcted to increaase. The
riskk is that the company
c doees not experieence growth.
Investing inn the shares of
o companiess that are in strongly
s grow
wing industriries means th hat
proofits are expeected to rise in
i the future. The firms shares
s price will be high relative to itts current
earnnings, so thee price-earnin ngs ratio willl be higher th han it is for other
o compannies. The
disaadvantage off buying such h shares is thhat if those fu
uture profits dont materiialise, the hig gh price-
earnnings ratio means
m the shaares are overrvalued and youll
y get a lower-than-avverage return n on
youur investmennt.
14 If wworld savingss declines at the same tim me world inv vestment rises, the supplyy curve of loaanable
funnds shifts to the
t left and th he demand ccurve shifts to o the right. Figure
F 8.6 illuustrates the result
r
thatt the world innterest rate will
w rise, whiile the overalll effect on th he equilibrium
um quantity of o
loannable funds is i ambiguous it dependds on how big g the shifts of
o the two cururves are relaative to
eacch other and on o their elastticities.
Figure 88.6
15 a Investment can be increased by reducing taxes on private saving or by reducing the
government budget deficit. But reducing taxes on private saving has the effect of decreasing
government income and increasing the possibility of a government budget deficit, unless
some other taxes are increased or government spending is reduced. So it is difficult to engage
in both policies at the same time.
b To know which of these policies would be a more effective way to raise investment, youd
need to know: (1) what the elasticity of private saving is with respect to the after-tax real
interest rate, since that would determine how much private saving would increase if you
reduced taxes on saving; (2) how private saving responds to changes in the government
budget deficit, since, for example, if Ricardian equivalence holds, the decline in the
government budget deficit would be matched by an equal decline in private saving, so
national saving wouldnt increase at all; and (3) how elastic investment is with respect to the
interest rate, since if investment is quite inelastic, neither policy will have much of an impact
on investment.
Tutorial week 5:

Review questions

1 Money is different from other assets in the economy because it is the most liquid asset available.
Other assets vary widely in their liquidity.
2 Commodity money is money with intrinsic value, like gold, which can be used for purposes other
than as a medium of exchange. Fiat money is money without intrinsic value; it has no value other
than its use as a medium of exchange. Our economy today uses fiat money.
3 Current deposits are balances in bank accounts that depositors can access on demand and are
included in the supply of money because they can be used to buy goods and services.
4 The cash rate is the interest rate that financial institutions earn on overnight loans of their
currency or reserves. The RBA targets the cash rate under the current inflation-targeting regime.
To achieve its cash rate target, the RBA undertakes open-market operations to affect the liquidity
conditions of banks through their exchange settlement accounts held at the Reserve Bank. A rise
in the cash rate is associated with a fall in the money supply.
5 The cash rate is the foundation rate for all interest rates in the economy. It is the rate financial
institutions charge one another for borrowing and lending. When the institutions lend to
individuals or businesses, the cash rate is used as the basis for determining the rate to charge.
6 Financial institutions say they no longer strictly follow movements in the cash rate because they
borrow in the financial markets and use borrowed funds as leverage to offer loans. If their
borrowing costs are higher than the cash rates, these financial institutions would need to charge
higher interest rates for the loans they offer.
7 Reserve requirements are regulations on the minimum amount of reserves that banks must hold
against deposits. The RBA no longer uses reserve requirements as a tool of monetary policy
because the decision about the amount of reserves to hold is more a matter of prudential control.
Changing reserve requirements can be disruptive to the business of banking. Rather it relies on
the more market-oriented cash rate as the tool of monetary policy. Banks do sometimes keep
more reserves than required.

8 The RBA cant control the money supply perfectly because: (1) the RBA doesnt control the
amount of money that households choose to hold as deposits in banks; and (2) the RBA does not
control the amount that bankers choose to lend. The actions of households and banks affect the
money supply in ways the RBA cant perfectly control or predict.
9 The term prudential supervision refers to the monitoring of the financial condition of banks
by a central agency. This role was traditionally undertaken by the RBA but is now the preserve of the
Australian Prudential Regulation Authority.

Problems:

1 a An Australian dollar coin is money in the Australian economy because it is used as a medium
of exchange to buy goods or services, it serves as a unit of account because prices in stores
are listed in terms of dollars and cents and it serves as a store of value for anyone who holds it
over time.
b A euro is not money in the Australian economy, because it is not used as a medium of
exchange and prices arent given in terms of euros, so it isnt a unit of account. It could serve
as a store of value, though.
c A Ferrari isnt money, because you cant exchange it for goods or services and prices arent
given in terms of Ferrari. It does, however, serve as a store of value.
d A smart card either accesses a cheque or savings account balances or is topped up with
transfers from your accounts. The card is not a medium of exchange but the account balance it
accesses or the amount topped up in the card pays for purchases. So a smart card is not a
medium of exchange and therefore not money. It is a tool to access or carry money.
2 a It would be difficult to run the economy using the barter system instead of money because it
requires finding a double coincidence of wants. Money works efficiently because it requires
satisfying peoples needs on just one side of each transaction; you buy something for money
and sell something else for money. With money, you dont have to buy something from
someone who wants something youre selling.
b Goods bartered from the newspaper column may exist because people take the view that they
can avoid paying taxes on things they buy and sell. It may also be the case that people enjoy
the process of swapping or alternatively they believe that the price that they receive through
a swap may be better than on the open market.
3 For an asset to be useful as a medium of exchange, it must be widely accepted (so all
transactions can be made in terms of it), recognised easily as money (so people can perform
transactions easily and quickly), divisible (so people can provide change) and difficult to
counterfeit (so people wont print their own money). The family home would not fulfil these
tasks easily. A home would not be easily divisible, nor would transactions be able to be made
quickly and easily and it could be copied.
For an asset to be useful as a store of value, it must be something that maintains its value
over time and something that can be sold when money is needed. The family home could
fulfil these tasks. Real estate is a good store of value. The family home is a physical asset,
since it can be converted into money relatively easily.
For an asset to be useful as a unit of account, it has to act as a yardstick that people can
use to post prices and record debts. The family home would be too big an asset to use to
record prices. For example, the price of a shirt would be too small a proportion of the family
home to be meaningful. Family homes can also vary in terms of size and quality and hence
different homes would provide a different yardstick.
4 a If more shops starting accepted bitcoin and this lead to greater use of the alternative means of
payment, this could affect the ability of the RBA to set monetary policy and target the cash
rate as the Australian (dollar) currency would decline in use as a method of payment. This
would reduce the RBAs ability to influence the money supply and the credit creation process.
b If someone in Australia discovered an easy way to counterfeit bitcoin, they could flood the
country with counterfeit currency, thus reducing its value. The result might be a switch to a
different type of currency that could prevent the counterfeiting.
5 When your aunt repays a $100 loan from Third State Bank (TSB) by writing a cheque from
her TSB cheque account, the result is a change in the assets and liabilities of both your aunt
and TSB, as shown in these T-accounts:

Your aunt
Assets Liabilities
_____________________________________________
Before:
Cheque account $100 | Loans $100
****************************************************************
After:
Cheque account $ 0 | Loans $ 0
Third State Bank
Assets Liabilities
_____________________________________________
Before:
Loans $100 | Deposits $100
****************************************************************
After:
Loans $ 0 | Deposits $ 0

By paying off the loan, your aunt simply eliminated the outstanding loans using the assets in her
cheque account. Your aunts wealth hasnt changed; she simply has fewer assets and fewer
liabilities.
6 a Here is BSBs T-account:

Beleaguered State Bank


Assets Liabilities
_____________________________________________
Reserves $25 million | Deposits $250 million
Loans $225 million |

b When BSBs largest depositor withdraws $10 million in cash and BSB reduces its loans
outstanding to maintain the same reserve ratio, its T-account is now:

Beleaguered State Bank


Assets Liabilities
_____________________________________________
Reserves $24 million | Deposits $240 million
Loans $216 million |

c Since BSB is cutting back on its loans, other banks will find themselves short of reserves and
they may also cut back on their loans as well.
d BSB may find it difficult to cut back on its loans immediately, since it cant force people to
pay off loans. Instead, it can stop making new loans. But for a time it might find itself with
more loans than it wants. It could try to attract additional deposits to get additional reserves,
or borrow from another bank or from the RBA.
7 Money supply would decrease by the amount of coins in circulation that are no longer
accepted as legal tender. Since coins make up a small proportion of total currency in
circulation and currency does not participate in the credit creation process, the decrease in
money supply is likely to be small. Regardless of the money demand elasticity, the impact on
the interest rate may also be relatively small.

12 a If people hold all money as currency, the quantity of money is $2000.


b If people hold all money as demand deposits at banks with 100 per cent reserves, the quantity
of money is $2000.
c If people have $1000 in currency and $1000 in current deposits, the quantity of money is
$2000.
d If banks have a reserve ratio of 10 per cent, the money multiplier is 1 / 0.10 = 10. So if people
hold all money as demand deposits, the quantity of money is 10 x $2000 = $20,000.
e If people hold equal amounts of currency (C) and current deposits (D) and the money
multiplier for reserves is 10, then two equations must be satisfied:
(1) C = D, so that people have equal amounts of currency and current deposits; and
(2) 10 x ($2000 C) = D, so that the money multiplier (10) times the number of dollar notes
that arent being held by people ($2000 C) equals the amount of current deposits (D).
Using the first equation in the second gives 10 x ($2000 D) = D, or $20,000 10 D = D, or
$20,000 = 11 D, so D = $1818.18. Then C = $1818.18.
The quantity of money is C + D = $3636.36.
Tutorial week 6:

Review Questions

1 When the price level rises, people have to pay more for the goods and services they buy.
Therefore, an increase in the price level means a lower value of money because each dollar in
your wallet now buys a smaller quantity of goods and services.
2 According to the quantity theory of money, the effect of a decrease in the quantity of money is a
decrease in the price level.
3 Nominal variables are those measured in monetary units, while real variables are those measured
in physical units. Examples of nominal variables include the prices of goods, wages and the
dollar value of GDP. Examples of real variables include relative prices (the price of one good in
terms of another), real wages and real GDP. According to the principle of monetary neutrality,
only nominal variables are affected by changes in the quantity of money.
4 Inflation is like a tax because as prices rise, everyone who holds money loses purchasing power.
In a hyperinflation, the government uses the inflation tax, instead of taxes on income, to finance
its spending. Very rapid money growth leads to high rates of inflation.
5 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.
6 The costs of inflation include shoeleather costs associated with reduced money holdings, menu
costs associated with more frequent adjustment of prices, increased variability of relative prices,
unintended changes in tax liabilities due to non-indexation of the tax laws, confusion and
inconvenience resulting from a changing unit of account and arbitrary redistributions of wealth
between debtors and creditors. With a low and stable rate of inflation like Australia experienced
200507, none of these costs are very high. Perhaps the most important one is the interaction
between inflation and the tax laws, which may reduce saving and investment even with a low
inflation rate.
7 If inflation is less than expected, creditors benefit and debtors lose. Creditors receive dollar
payments from debtors that have a higher real value than was expected.

Problems:

1 The case for inflation targeting as a monetary policy object is made with reference to the quantity
theory of money (M x V = P x Y), which relates the quantity of money to the nominal value of
output. Assuming the velocity of money is relatively stable over time, if the central bank were to
change the quantity of money, it would cause proportionate changes in the nominal value of
output. With output determined by factor inputs and technology, if the central bank alters the
money supply and induces parallel changes in the nominal value of output, the changes are
reflected in changes in the price level.
3 Lenin is right that governments can confiscate the wealth of citizens with inflation. Inflation acts
like a tax on people who hold money, by reducing its value. The government can finance its
expenditures by printing money and using it to buy things, which results in a higher money
supply and inflation. The result is a transfer of wealth from money-holders to the government.
4 If a countrys inflation rate increases sharply, the inflation tax on holders of money increases
significantly. Wealth in savings accounts isnt subject to a change in the inflation tax because the
nominal interest rate will increase with the rise in inflation. But holders of savings accounts are
hurt by the increase in the inflation rate because they are taxed on their nominal interest income,
so their real returns are lower.
5 Hyperinflations usually arise when governments try to finance much of their expenditures by
printing money. This is unlikely to occur if the central bank is independent of the government as
is the case in Australia.
6 a The total cost of purchasing equal amounts of potatoes and carrots equals the quantity of each
good times its price, added together for all goods. That is, if x is the quantity of potatoes,
which also equals the quantity of carrots, then the cost of potatoes and carrots for the year is x
(PP + PC). In the second year, the cost is x (PP + PC), where the mark refers to the price in
the second year. Then we can define a price index with a value of one in the first year. In the
second year, the price index has the value of the cost of goods in the second year divided by
the cost of goods in the first year. Thus the price index in the second year is x (PP + PC) / x
(PP + PC) = (PP + PC) / (PP + PC) = ($6 + $7.50) / ($5 + $3) = $13.50 / $8 = 1.687. Bob is
worse off because the price of potatoes increased 20 per cent while inflation increased be 68.7
per cent, so the prices of the goods he sells rose slower than the price of the goods (carrots) he
buys. Rita is better off because carrots increased by 150 per cent while inflation was 68.7 per
cent, so the prices of the goods she sells rose faster than the price of the goods (potatoes) she
buys.
b If the price of potatoes rises to $6 and the price of carrots remains at $3, then the price index
in the second year is (PB + PR) / (PB + PR) = ($6 + $3) / ($5 + $3) = $9 / $8 = 1.125, so the
inflation rate is (1.125 1) / 1 x 100 per cent = 12.5 per cent. Bob is better off because the
price of potatoes increased 20 per cent while inflation was only 12.5 per cent. Rita is worse
off because inflation was 12.5 per cent, so the prices of the goods she buys rose faster than the
price of the goods (carrots) she sells, which did not change.
c If the price of potatoes falls to $4 and the price of carrots falls to $2.50, then the price index in
the second year is (PB + PR) / (PB + PR) = ($4 + $2.50) / ($5 + $3) = $6.50 / $8 = 0.8125, so
the inflation rate is (0.8125 1) / 1 x 100 per cent = 18.75 per cent. Bob is worse off because
his dollar revenues fall by 20 per cent but overall prices fell by only 18.75 per cent. Rita is
better off because her dollar revenues fall by 16.67 per cent, which is less than the deflation of
18.75 per cent, so the prices of the goods she sells didnt fall as fast as the price of the goods
(potatoes) she buys.
8 If you lived in a low-inflation economy, you would hold wealth in assets such as cash that would
lose value only slowly over time.
9 a Unexpectedly low inflation hurts the federal government by providing lower inflation tax
revenue and increasing the real value of outstanding government debt.
b Unexpectedly low inflation hurts a homeowner with a fixed-rate mortgage because she pays a
fixed nominal interest rate that was based on expected inflation and thus pays a higher real
interest rate than was expected.
c Unexpectedly low inflation neither helps nor hurts a casual worker who has no labour
contract because his real wage is the same since his nominal wages, without a binding
contract, can be adjusted according to the inflation rate.
d Unexpectedly low inflation helps a private school that has invested some of its endowment in
Treasury bonds because the lower inflation rate means the school is receiving a higher real
interest rate than it had planned.
10 The redistribution from creditors to debtors is something that happens when inflation is
unexpected, not when it is expected. The problems that occur with both expected and unexpected
inflation include shoeleather costs associated with reduced money holdings, menu costs
associated with more frequent adjustment of prices, increased variability of relative prices,
unintended changes in tax liabilities due to non-indexation of the tax code and the confusion and
inconvenience resulting from a changing unit of account.
11 a The statement that Inflation hurts borrowers and helps lenders, because borrowers must pay a
higher rate of interest is false. Higher expected inflation means borrowers pay a higher
nominal rate of interest but its the same real rate of interest, so borrowers arent worse off
and lenders arent better off. Higher unexpected inflation, on the other hand, makes borrowers
better off and lenders worse off.
b The statement that If prices change in a way that leaves the overall price level unchanged,
then no one is made better or worse off is false. Changes in relative prices can make some
people better off and others worse off, even though the overall price level doesnt change. See
problem 6 for an illustration of this.
c The statement that Inflation does not reduce the purchasing power of most workers
is true. Most workers incomes keep up with inflation reasonably well.