Chapter 7 Notes

Question 1

Where does inflation come from?

Answer 1

Inflation is a result of the Fed and the banking system increasing the money supply

Question 2

How can all consumers spend more money on all goods and services, without reducing their nominal savings?

Answer 2

The money supply must have increased

Question 3

What is the formula for the equation of exchange?

Answer 3

MV=PQ

Question 4

What does V stand for in the equation of exchange? Define it.

Answer 4

Velocity is the average number of times a dollar changes hands in a year.

Question 5

What is the common sense interpretation of the equation of exchange?

Answer 5

A year’s worth of output in the economy is bought by the money supply, which is spent and re-spent V times per year

Question 6

Where does inflation come from?

Answer 6

Inflation is a result of the Fed and the banking system increasing the money supply

Question 7

Which assumptions does the simple quantity theory rest on?

Answer 7

The equation of exchange applies. Velocity is constant. Output is constant.

Question 8

What is the prediction of the simple quantity theory?

Answer 8

The price level and the money supply are proportionally related.

Question 9

Who founded the monetarist school of economics?

Answer 9

Milton Friedman

Question 10

What assumptions does monetarism make about the equation of exchange?

Answer 10

Velocity is a stable function of a few variables. Output may change in the short run, but in the long run, output is at the economy’s potential, with labor markets at equilibrium

Question 11

What happens in the short run and in the long run in Friedman’s “helicopter drop” story?

Answer 11

In the short run, prices and output increase. In the long run, wages increase, causing output to be restored to potential, but with higher prices.

Question 12

Under what conditions would inflation have zero effect on the economy?

Answer 12

If it is wholly anticipated and evenly spread throughout the economy

Question 13

If all prices in the economy double, how does the amount of goods and services produced change?

Answer 13

The amount of goods and services produced do not change. The reward to production, in terms of goods and services, is the same as before the price change

Question 14

What is a way to avoid being made worse off by anticipated inflation?

Answer 14

Buy goods whose prices inflate before the inflation starts

Question 15

True, false, explain: With unanticipated inflation, borrowers gain and lenders lose

Answer 15

True. The borrower pays off the loan with inflated dollars, which are worthless.

Question 16

What is the real interest rate?

Answer 16

Real rate = nominal rate = expected inflation rate

Question 17

What is a secured loan?

Answer 17

A loan in which the lender can seize the borrower’s property if the loan is not repaid

Question 18

What are the two problems with uneven inflation?

Answer 18

Prices no longer reflect value, so mistakes are made. Bubbles expand as systematic mistakes are made due to the inflation

Question 19

Which economic “school” emphasized inflationary bubbles?

Answer 19

The Austrian school–Hayes, Mises, etc.

Question 20

When someone pays an interest rate to someone, what are they paying that person to do?

Answer 20

To delay consumption

Question 21

What is the difference between dollars saved and dollars created by the Fed?

Answer 21

Dollars saved have the potential to fuel later consumption, since they represent delayed consumption. Dollars made by the Fed do not have this potential.

Question 22

What happens when a Fed-created inflationary bubble bursts?

Answer 22

Unwanted capital goods and constructions are abandoned and the workers that produced them must all find new jobs.

Question 23

Why do the Austrians say that government and the central bank create bubbles, though private markets do not?

Answer 23

Because there must be coordinated failures by many individuals and firms. Government, especially through a government money supplier is the best coordinator.

Question 24

What is “monetizing the debt?”

Answer 24

The central bank attempts to assist the state in its borrowing by purchasing debt in return for dollars

Question 25

What is “the inflationary tax?”

Answer 25

When money growth causes inflation, borrowers gain and lenders lose, so governments, who borrow a lot, can sap their lenders by creating inflation and paying with lower valued dollars.

Question 26

What was the difference between inflation using gold as money and inflation using dollars not backed by gold?

Answer 26

Inflation using gold was very low. Inflation using unbacked dollars was high.

Question 27

What was the cause of inflation in the late 1960s?

Answer 27

The Fed’s monetizing the debt to support the Vietnam war

Question 28

Which Fed chairman was able to end the 1970s inflation?

Answer 28

Paul Volcker

Question 29

How much inflation do many view as “normal?”

Answer 29

3%

Question 30

With 3% inflation, how long does it take the value of one’s savings to be cut in half?

Answer 30

24 years

Question 31

How does the federal government (not the Fed) affect the credit market?

Answer 31

The federal government is the largest borrower, so it is a major part of the demand for loanable funds

Question 32

True, False, explain: If the federal government increases borrowing by $500B, the total amount of loans increases by $500B.

Answer 32

False. As the federal government increases the demand for loanable funds, interest rates rise, which lowers the incentives for consumers and businesses to borrow, resulting in less private borrowing–crowding out

Question 33

True, false, explain: Credit markets do not create value, they only move value around.

Answer 33

False. Like all voluntary trade, borrowing and lending create value as resources flow to the highest valued uses.

Question 34

Bastiat says, “…actually nobody borrows money for the sake of the money…” What does he mean?

Answer 34

We borrow money for the sake of the goods, services, and resources. Money is only the medium by which we exchange.

Question 35

What is the difference between stocks and bonds?

Answer 35

Someone who owns a company’s stock, owns part of the company. Someone who owns the company’s bond is the company’s creditor.

Question 36

How can a leveraged buyout create value?

Answer 36

A badly managed firm owns assets that are worth more than the stock value. Another firm borrows, buys the stock, then sells the assets to those who are willing to pay more for the assets because they can better manage them.

Question 37

What is a difference between illiquidity and insolvency?

Answer 37

Illiquidity means that a firm does not have enough spendable cash to pay its current bills. Insolvency means that the firm owns less than it owes.

Question 38

True, False, explain: A $100M firm that goes bankrupt costs the economy $100M.

Answer 38

False. Any bankrupt firm likely has some valuable assets. The true economic loss was in badly managing the assets. The bankruptcy, at worst, distributes the assets to higher valued uses.

Question 39

What is the absolute priority rule? Explain.

Answer 39

The rule says that the highest ranked bondholders are paid everything they are owed first, etc., with the stockholders payed last.

Question 40

True, False, explain: Bastiat said that the only reason the government should not get involved in guaranteeing loans to the less creditworthy is that the taxpayers are on the hook.

Answer 40

False. Bastiat’s main objection is that guaranteeing a loan for a less creditworthy borrower means that fewer funds are available for creditworthy borrowers.

Question 41

Bastiat said, “To save is to spend.” What did he mean?

Answer 41

Dollars that are saved, fuel investment and consumption, so saving is spending by another means

Question 42

Fannie Mae was the major player in “the secondary market for home lending.” What does that mean?

Answer 42

Fannie Mae bought home loans from banks and sold bonds to the public, which were backed by the loan payments

Question 43

What is a nonconforming loan?

Answer 43

A loan in which the borrower is a high credit risk