Final Exam Flashcards
Which of the following is a generally accepted medium of exchange? A. a plane ticket B. federal government bonds C. fine art D. currency
D. currency
What do economists use the word “money” to refer to?
A. income generated by the production of goods and services
B. those assets regularly used to buy goods and services
C. the value of a person’s assets
D. the value of stocks and bonds
B. those assets regularly used to buy goods and services
Which of the following is current Canadian currency?
A. fiat money with intrinsic value
B. fiat money with no intrinsic value
C. commodity money with intrinsic value
D. commodity money with no intrinsic value
B. fiat money with no intrinsic value
Which of the following is included in M1? A. government bonds B. demand deposits C. savings deposits D. travellers’ cheques
B. demand deposits
How are credit card balances treated in M1 as compared to M2?
A. They are included in M1 but not M2.
B. They are included in M2 but not M1.
C. They are included in M1 and M2.
D. They are included in neither M1 nor M2.
D. They are included in neither M1 nor M2.
Which of the following is the fundamental function of credit cards?
A. Credit cards are used for deferring payments.
B. Credit cards are used as store of value.
C. Credit cards are used for increasing the money supply.
D. Credit cards are used as investment assets.
A. Credit cards are used for deferring payments.
Given the size of the Canadian money stock, is the amount of currency per person reasonable?
A. Yes, the amount of currency per person is about right.
B. There is no way of determining the amount of currency in circulation.
C. No, there is too little currency per person.
D. No, there is too much currency per person.
D. No, there is too much currency per person.
Which of the following agencies is responsible for regulating the money supply in Canada? A. the Comptroller of the Currency B. the Bank of Canada C. the TD Bank D. the Canadian Payments Association
B. the Bank of Canada
For how long is the governor of the Bank of Canada appointed? A. life B. a seven-year term C. a five-year term D. a two-year term
B. a seven-year term
What is the role of the Minister of Finance with respect to the Bank of Canada or the banking system?
A. to control all activities of the Bank of Canada
B. to issue the Governor of Bank of Canada a written directive to resign
C. to issue currency
D. to maintain the stability of the banking system
B. to issue the Governor of Bank of Canada a written directive to resign
How do deposits and reserves appear on a bank’s T-account?
A. Both deposits and reserves are assets.
B. Both deposits and reserves are liabilities.
C. Deposits are assets and reserves are liabilities.
D. Reserves are assets and deposits are liabilities.
D. Reserves are assets and deposits are liabilities.
Suppose a bank has $200 000 in deposits and $180 000 in loans. What is its reserve ratio? A. 1 percent B. 5 percent C. 10 percent D. 18 percent
C. 10 percent
When a bank loans out $1000, what happens to the money supply?
A. It does not change.
B. It decreases.
C. It increases.
D. It has an indeterminate effect on the money supply.
C. It increases.
If the reserve ratio is 7 percent and a bank receives a new deposit of $300, which of the following will this bank most likely do?
A. It will increase required reserves by $2100.
B. It will initially see reserves increase by $279.
C. It will be able to make new loans up to a maximum of $279.
D. It will be able to increase its required reserves by $30.
C. It will be able to make new loans up to a maximum of $279.
A central bank raised the reserve requirement ratio from 10 percent to 12 percent. Other things the same, how does the money multiplier change? A. It increases by 1.67. B. It decreases by 1.67. C. It increases by about 2. D. It decreases by 2.
B. It decreases by 1.67.
Assets: Reserves=$100 Loans=$900 Liabilities: Deposits=$1000
If the Bank of Edmonton has loaned out all the money it wants, given its deposits, what is its reserve ratio? A. 1 percent B. 5 percent C. 10 percent D. 15 percent
C. 10 percent
Assets: Reserves=$100 Loans=$900 Liabilities: Deposits=$1000
Assume that the Bank of Edmonton is holding the required percent of deposits as reserves. Also, assume all other banks hold only the required percent of deposits as reserves, and that people hold only deposits and no currency. What is the money multiplier? A. 1 B. 5 C. 10 D. 15
C. 10
Assets: Reserves=$100 Loans=$900 Liabilities: Deposits=$1000
Assume that all other banks hold only the required 5 percent of deposits as reserves and people hold only deposits and no currency. If the Bank of Edmonton decides to hold exactly 5 percent reserves, by how much would the economy’s money supply increase? A. $500 B. $1000 C. $1500 D. $2000
B. $1000
If a bank uses $80 of excess reserves to make a new loan when the reserve ratio is 25 percent, what happens to the money supply?
A. The money supply initially decreases by $80.
B. The money supply initially increases by $20.
C. The money supply will eventually increase by more than $20 but less than $80.
D. The money supply will eventually increase by $320.
D. The money supply will eventually increase by $320.
In Wellville, the money supply is $80 000 and reserves are $18 000. Assuming that people hold only deposits and no currency, and that banks hold only required reserves, what is the required reserve ratio? A. 29 percent B. 22.5 percent C. 16 percent D. 4.44 percent
B. 22.5 percent
At one time, the country of Freedonia had no banks, but had currency of $40 million. Then a banking system was established with a reserve requirement of one-third. The people of Freedonia now keep half their money in the form of currency and half in the form of bank deposits. If banks do not hold excess reserves, how much currency do the people of Freedonia now hold? A. $13.33 million B. $20 million C. $30 million D. $36.36 million
C. $30 million
Suppose the banking system has $10 million in reserves, the reserve requirement is 20 percent, and there are no excess reserves. The public holds $10 million in cash. Then bankers decide that it is prudent to hold some excess reserves, and so begin to hold 25 percent of deposits in the form of reserves. Other things the same, what will this action cause the money supply to do? A. to change forms, but not size B. to fall by $10 million C. to fall by $5 million D. to fall by $0.5 million
B. to fall by $10 million
Which of the following lists contains only actions that increase the money supply?
A. make open market purchases; raise the reserve requirement ratio
B. make open market purchases; lower the reserve requirement ratio
C. make open market sales; raise the reserve requirement ratio
D. make open market sales; lower the reserve requirement ratio
B. make open market purchases; lower the reserve requirement ratio
Which of the following lists ranks the Bank of Canada’s monetary policy tools from most to least frequently used?
A. bank rate changes; reserve requirement changes; open market transactions
B. reserve requirement changes; open market transactions; bank rate changes
C. open market transactions; bank rate changes; reserve requirement changes
D. open market transactions; reserve requirement changes; bank rate changes
C. open market transactions; bank rate changes; reserve requirement changes
Which of the following is not a tool of monetary policy? A. open market operations B. reserve requirements C. changing the bank rate D. increasing the deficit
D. increasing the deficit
How may the Bank of Canada influence the price level?
A. by conducting open market sales and raising the bank rate
B. by conducting open market sales and lowering the bank rate
C. by conducting open market purchases and raising the bank rate
D. by conducting open market purchases and lowering the bank rate
D. by conducting open market purchases and lowering the bank rate
When and where did hyperinflation occur? A. during 1880–1896 in the United States B. in post–World War I Germany C. during the 1970s in Canada D. during 1930–1933 in the United States
B. in post–World War I Germany
Which of the following does the classical theory of inflation try to explain?
A. changes in relative prices in the economy determined by factors other than inflation
B. the effect of inflation on economic growth
C. the short-run determinants of the price level and the inflation rate
D. the long-run determinants of the price level and the inflation rate
D. the long-run determinants of the price level and the inflation rate
When the value of money rises, what happens to the number of dollars needed to buy a representative basket of goods?
A. It increases, and so the price level rises.
B. It increases, and so the price level falls.
C. It decreases, and so the price level rises.
D. It decreases, and so the price level falls.
D. It decreases, and so the price level falls.
Why is the money supply curve vertical?
A. because the quantity of money supplied increases when the value of money increases
B. because the quantity of money supplied increases when the value of money decreases
C. because the quantity of money supplied increases only if people desire to hold more money
D. because the quantity of money supplied increases only if the central bank increases the money supply
D. because the quantity of money supplied increases only if the central bank increases the money supply
How is the supply of money determined? A. by the price level B. by the Ministry of Finance C. by the Bank of Canada D. by the demand for money
C. by the Bank of Canada
When the money market is depicted in a graph with the value of money on the vertical axis, as the price level increases, which of the following happens to the value of money?
A. It increases, so the quantity of money demanded increases.
B. It increases, so the quantity of money demanded decreases.
C. It decreases, so the quantity of money demanded decreases.
D. It decreases, so the quantity of money demanded increases.
D. It decreases, so the quantity of money demanded increases.
Which of the following best describes the effects of an open market operation undertaken by the Bank of Canada?
A. If the Bank of Canada purchases bonds in the open market, then the money supply shifts right and the price level increases.
B. If the Bank of Canada sells bonds in the open market, then money supply shifts right and the price level decreases.
C. If the Bank of Canada purchases bonds, then the money supply shifts left and the price level decreases.
D. If the Bank of Canada sells bonds, then the money supply shifts right and the price level decreases.
A. If the Bank of Canada purchases bonds in the open market, then the money supply shifts right and the price level increases.
When the money market is depicted in a diagram with the value of money on the vertical axis, in which of the following situations does the value of money increase?
A. if either money demand or money supply shifts right
B. if either money demand or money supply shifts left
C. if money demand shifts right or money supply shifts left
D. if money demand shifts left or money supply shifts right
C. if money demand shifts right or money supply shifts left
In the 14th century, the Western African Emperor Kankan Musa travelled to Cairo where he gave away much gold, which was in use as a medium of exchange. Which of the following would we predict this increase in gold would do to the price level and value of gold in Cairo?
A. raise both the price level and the value of gold in Cairo
B. raise the price level, but decrease the value of gold in Cairo
C. lower the price level, but increase the value of gold in Cairo
D. lower both the price level and the value of gold in Cairo
B. raise the price level, but decrease the value of gold in Cairo
In the 1970s in response to recessions caused by an increase in the price of oil, the central banks in many countries increased the money supply. How might the central banks have done this?
A. by selling bonds on the open market, which would have raised the value of money
B. by purchasing bonds on the open market, which would have raised the value of money
C. by selling bonds on the open market, which would have raised the value of money
D. by purchasing bonds on the open market, which would have lowered the value of money
D. by purchasing bonds on the open market, which would have lowered the value of money
When the money market is depicted in a diagram with the value of money on the vertical axis, which of the following happens if the price level is above the equilibrium level?
A. There is a shortage, so the price level will rise.
B. There is a shortage, so the price level will fall.
C. There is a surplus, so the price level will rise.
D. There is a surplus, so the price level will fall.
B. There is a shortage, so the price level will fall.
In a graph, on the vertical axis is the Value of Money and horizontal axis is the Quantity of Money. MS1 shifts to the right to become MS2. The equilibrium value of money went fro 2 to 1.
If the money supply is MS2 and the value of money is 2, which of the following relationships holds?
A. The value of money is less than its equilibrium level.
B. The price level is higher than its equilibrium level.
C. Money demand is greater than the money supply.
D. The money supply is greater than money demand.
D. The money supply is greater than money demand.
In a graph, on the vertical axis is the Value of Money and horizontal axis is the Quantity of Money. MS1 shifts to the right to become MS2. The equilibrium value of money went fro 2 to 1.
What happens when the money supply curve shifts from MS1 to MS2?
A. The demand for goods and services decreases.
B. The economy’s ability to produce goods and services increases.
C. The equilibrium price level increases.
D. The equilibrium value of money increases.
C. The equilibrium price level increases.
Which of the following terms refers to economic variables whose values are measured in monetary units? A. dichotomous variables B. nominal variables C. classical variables D. real variables
B. nominal variables
Which of the following does nominal GDP measure?
A. the total quantity of final goods and services produced
B. the dollar value of the economy’s output of final goods and services
C. the total income received from producing final goods and services in constant dollars
D. the price level
B. the dollar value of the economy’s output of final goods and services
Which of the following does real GDP measure?
A. the total quantity of final goods and services produced
B. the dollar value of the economy’s output of final goods and services
C. the total income received from producing final goods and services at current prices
D. the change in prices from the base year to current year
A. the total quantity of final goods and services produced
What type of variable is the price level? A. a relative variable B. an actual variable C. a real variable D. a nominal variable
D. a nominal variable
What is the price of a Honda Accord divided by the price of a Honda Civic called? A. a classical variable B. a dichotomous variable C. a nominal variable D. a real variable
D. a real variable
An assistant professor of economics gets a $100-a-month raise, but then she figures that with her current monthly salary she can’t buy as many goods as she could last year. Which of the following has happened to her real and nominal wage?
A. Her real and nominal wages have risen.
B. Her real and nominal wages have fallen.
C. Her real wage has risen and her nominal wage has fallen.
D. Her real wage has fallen and her nominal wage has risen.
D. Her real wage has fallen and her nominal wage has risen.
Which of the following kinds of variables are interest rates adjusted for the effects of inflation? A. nominal variables B. real variables C. classical variables D. dichotomous variables
B. real variables
According to the classical dichotomy, which of the following increases when the money supply increases? A. the real interest rate B. real GDP C. the real wage D. the price level
D. the price level
According to the classical dichotomy, which of the following is NOT influenced by monetary factors?
A. nominal GDP and nominal interest rates
B. real wages and real GDP
C. the price level and nominal GDP
D. the price level and nominal GDP
B. real wages and real GDP
How is velocity computed? A. (PY)/M B. (PM)/Y C. (YM)/P D. (YM)/V
A. (PY)/M
Based on the quantity equation, if M = 125, V = 4, and Y = 200, what is P? A. 0.5 B. 1 C. 1.5 D. 2.5
D. 2.5
According to the quantity equation, if Y and M are constant, and V doubles, which of the following will happen to the price level?
A. It will less than double.
B. It will double.
C. It will more than double.
D. It might double, more than double, or less than double; more information is needed.
B. It will double.
Assuming that velocity is stable, if real GDP grows by 10 percent this year, and if the money supply does not change this year, how does the price level or nominal GDP change?
A. The price level will not change.
B. Nominal GDP will grow by 10 percent.
C. Nominal GDP will stay the same.
D. The price level will increase by 10 percent.
C. Nominal GDP will stay the same.
Velocity in the country of Shem is always stable. In 2009, the money supply was $200 billion and the GDP price deflator was four times as high as it was in the base year. In 2010, the money supply increased to $240 billion, the price level increased by 15 percent, and nominal GDP equalled $1200 billion. By how much did real GDP increase between 2009 and 2010?
A. 20 percent
B. 4.35 percent
C. 2.17 percent
D. There is not enough information to answer the question.
B. 4.35 percent
Which of the following best explains why governments may prefer an inflation tax to some other kind of tax?
A. The inflation tax is easier to impose.
B. The inflation tax reduces inflation.
C. The inflation tax falls mainly on high-income individuals.
D. The inflation tax reduces the real cost of government expenditure.
A. The inflation tax is easier to impose.
What is the name of the one-for-one adjustment of the nominal interest rate to the inflation rate? A. the Friedman Effect B. the Hume Effect C. the Fisher Effect D. the Ricardian equivalence effect
C. the Fisher Effect
Greta puts money in a savings account at her bank earning 6.5 percent. One year later she takes her money out and notes that while her money was earning interest, prices rose 3.5 percent. Which of the following does Greta now have?
A. 3.5 percent more money with which she can purchase 6.5 percent more goods
B. 6.5 percent more money with which she can purchase 3 percent more goods
C. 6.5 percent more money with which she can purchase 6.5 percent more goods
D. 10 percent more money with which she can purchase 3 percent more goods
B. 6.5 percent more money with which she can purchase 3 percent more goods
Which of the following does the shoeleather cost of inflation refer to?
A. the fall in real income associated with inflation
B. the time spent searching for low prices when inflation rises
C. the waste of resources used to maintain lower money holdings
D. the increased cost to the government of printing more money
C. the waste of resources used to maintain lower money holdings
Which of the following terms refers to the cost of changing price tags and price listings? A. inflation-induced tax distortions B. relative-price variability costs C. shoeleather costs D. menu costs
D. menu costs
Given a nominal interest rate of 7 percent, in which of the following cases would you earn the lowest after-tax real rate of interest?
A. Inflation is 4 percent, and the tax rate is 25 percent.
B. Inflation is 3 percent, and the tax rate is 20 percent.
C. Inflation is 2 percent, and the tax rate is 15 percent.
D. Inflation is 1 percent, and the tax rate is 10 percent.
A. Inflation is 4 percent, and the tax rate is 25 percent.
Under which of the following conditions is wealth distributed from debtors to creditors? A. When inflation is high, but expected. B. When inflation is low, but expected. C. When inflation is unexpectedly high. D. When inflation is unexpectedly low.
D. When inflation is unexpectedly low.
Inflation vs Deflation vs Hyperinflation
Inflation: The increase in the overall level of prices.
Deflation: The decrease in the overall level of prices.
Hyperinflation: An extraordinarily high rate of inflation.
Why do economists use the “Classical Theory of Inflation” today?
To explain the long-run determinants of the price level and the inflation rate.
Name the determinants of price level and inflation rate in the “Classical Theory of Inflation.”
A) The level of prices and the value of money
B) Money supply, money demand and monetary equilibrium
C) Effects of a monetary injection
D) Classical dichotomy and monetary neutrality
E) Velocity and quantity equation
F) Inflation tax
G) Fisher Effect
“Classical Theory of Inflation” - Determinant: The Level of Prices and the Value of Money (Theory of Inflation)
- inflation is more about the value of money than the value of goods
- key point: Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.
- a rise in the price level means a lower value of money because each dollar in your wallet buys a smaller quantity of goods and services
- **price level rises = value of money falls (Value of money = 1/P (price of goods)
What happens to the value of money when price levels rise?
***price level rises = value of money falls
Value of money = 1/P (price of goods)
“Classical Theory of Inflation” - Determinant: Money supply, money demand, and monetary equilibrium (Quantity theory of money)
- value of money is determined by supply and demand for money
- supply of money determined by Bank of Canada
- demand determined by how much wealth people want to hold in liquid form
- in the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply
How can the Bank of Canada reduce the money supply?
- increasing overnight rate discourages banks from borrowing from Bank of Canada = reduction in quantity of reserves in banking system = reduces money supply
- Bank of Canada sells bonds in open-market and receives dollars = money supply contracts
Which factors influence the quantity of money demanded or the preference for holding wealth in liquid form?
- how much people rely on credit cards
- whether an automated teller machine is easy to find
- depends on the interest rate a person could earn by using the money to buy an interest-bearing bond instead of leaving it in the wallet or a low-interest chequing account
- average level of prices in the economy (money is a medium of exchange to buy goods and services, so the prices of these goods and services is also a factor)
What happens to the quantity of money demanded when price levels increase?
- the higher the prices are, the more money the typical transaction requires and the more money people will choose to hold in their wallets and chequing accounts
- the higher the price level, the lower the value of money, the quantity of money demanded increases
How is monetary equilibrium maintained if the price level is above equilibrium?
-people will want to hold more money than the Bank of Canada has created, so the price level must fall to balance supply and demand
If the value of money (1/P) is on the left vertical axis, the price level (P) is on the right vertical axis (increases from top to bottom) and the quantity of money is on the horizontal axis. How are money supply and money demand shown on the graph?
- money supply curve is vertical because the quantity of money supplied is fixed by the Bank of Canada
- money demand curve is downward sloping because people want to hold a larger quantity of money when each dollar buys less
“Classical Theory of Inflation” - Determinant: The Effects of Monetary Injection (Quantity theory of money)
- change in monetary policy
- economy is in equilibrium and then Bank of Canada doubles the supply of money by printing more bills = monetary injection
- supply curve moves from MS1 to MS2 and equilibrium moves from point A to B
- value of money decreases and equilibrium price level increases (increase in money supply makes dollars more plentiful, increases price level and makes each dollar less valuable)
Def: Quantity theory of money
A theory asserting that the quantity of money available determines the price level and the growth rate in the quantity of money available determines the inflation rate
What happens to an economy who was at equilibrium, but then the Bank of Canada decides to do a monetary injection by increasing the supply of money?
An increase in the supply of money:
- people now have more money in their wallets than they want (money supplied exceeds money demanded) so try to get rid of it by buying goods and services or make loans to others by depositing in the bank
- increases the demand for goods and services, but the economy’s ability to supply goods and services has not changed
- increases the price level (prices of goods and services increases due to increase in demand for them) which increases the quantity of money demanded because people are using more dollars for every transaction
- decreases the value of money
“Classical Theory of Inflation” - Determinant: Classical dichotomy and monetary neutrality
- classical dichotomy: the theoretical separation of nominal and real variables
- monetary neutrality: the proposition that changes in the money supply affect nominal variables, but do not affect real variables
- when central bank doubles money supply, all prices double and value of unit of account falls by half ; government reduces length of metre from 100 to 50 cm, all measured distances would double, but the actual distances (real variables) would remain the same
- monetary neutrality does apply in the long run, but maybe not in the short run
Nominal vs Real variables in Classical dichotomy
Nominal variable: variables measured in monetary units (Nominal GDP, prices)
Real variable: variables measured in physical units (Real GDP, relative prices, real wage, real interest rate), not influenced by prices, some adjusted for inflation
Nominal vs Real GDP
Nominal GDP: measures the dollar value of the economy’s output of goods and services (nominal variable in classical dichotomy)
Real GDP: measures the total quantity of goods and services produced and is not influenced by the current prices of those goods and services (real variable in classical dichotomy)
Def: Relative prices
The price of one thing compared to another where the dollar signs cancel out ($/$), making it a real variable since it is now measured in physical units.
Def: Real wage
- dollar wage adjusted for inflation
- real variable
- measures the rate at which the economy exchanges goods and services for each unit of labour
Def: Real interest rate
- the nominal interest rate adjusted for inflation
- real variable
- measures the rate at which the economy exchanges goods and services produced today for goods and services produced in the future
“Classical Theory of Inflation” - Determinant: Velocity and the Quantity Equation
-Velocity of money: the rate at which money changes hands
-V=(PY)/M
V=velocity of money
P=price level (GDP deflator)
Y=quantity of output (real GDP)
M=quantity of money
-Quantity Equation: MV=P*Y which relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services
-velocity of money is relatively stable (so assume constant velocity)
According to the quantity equation (MV=PY), what happens to the three variables if the quantity of money increases in the economy?
- the price level (P) must rise
- quantity of output (Y) must rise
- velocity of money (V) must fall
Name the 5 steps and key points of the quantity theory of money.
1) The velocity of money is relatively stable over time.
2) Because velocity is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (PY)
3) The economy’s output of goods and services (Y) is primarily determined by factor supplies (labour, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output.
4) With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (PY), these changes are reflected in changes in the price level (P).
5) Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.
How is hyperinflation defined and how can it be used in the economy?
- defined as inflation that exceeds 50% per month, so price level increases more than 100-fold over the course of a year
- changes in money supply and price level are so large, but move together
- used to study the effects of money on the economy
- prices rise when the government prints too much money
Why do central banks of countries who experienced hyperinflation choose to print so much money that its value is certain to fall rapidly over time?
-governments of these countries use money creation as a way to pay for their spending (build roads, pay salaries, give transfer payments to the poor or elderly)
“Classical Theory of Inflation” - Determinant: Inflation Tax
- The revenue the government raises by creating money.
- not like other taxes since no one receives a bill from the government, it’s more subtle
- when the government prints money, the price level rises, and the dollars in your pocket are less valuable
- inflation tax is like a tax on everyone who holds money
- leads to hyperinflation
How can hyperinflation end?
-when the government institutes fiscal reforms like cuts in government spending and to eliminate the need for the inflation tax
How do you calculate the real interest rate?
Real interest rate = Nominal interest rate - Inflation rate
Nominal interest rate: tells you how fast the dollars in your account will rise over time
Real interest rate: corrects the nominal interest rate for the effect of inflation to tell you how fast the purchasing power of your savings account will rise over time
“Classical Theory of Inflation” - Determinant: The Fischer Effect
- when the Bank of Canada increases the rate of money growth, the result is both a higher inflation rate and a higher nominal interest rate
- Fischer effect=one-for-one adjustment of nominal interest rate to inflation rate
- does not hold in the short run (only long run)
What is the inflation fallacy?
- what people think: when prices rise, each dollar buys fewer goods and services, so inflation directly lowers living standards
- FALSE!
- inflation does NOT reduce people’s real purchasing power, because when prices rise, buyers pay more but those selling get a bigger income (inflation in income goes hand in hand with inflation in prices = monetary neutrality)
- inflation=tax on holders of money
Costs of inflation: Shoeleather costs
- the resources wasted when inflation encourages people to reduce their money holdings
- inflation=tax on holders of money
- taxes are an incentive for people to alter their behaviour to avoid paying it so causes deadweight losses for society as a whole and people waste scarce resources trying to avoid it
- inflation erodes the real value of money in your wallet so to avoid the inflation tax, you hold less money (go to bank more often)
- cost of reducing money holdings=shoeleather cost, where cost of time and convenience is sacrificed
- really affects countries experiencing hyperinflation
Costs of inflation: Menu costs
- the costs of changing prices
- typical Canadian firms change prices once a year, but for countries in hyperinflation, prices need to be changed daily to keep up with all other prices in the economy
- menu costs include cost of deciding on prices, cost of printing new catalogues, cost of advertising, cost of dealing with annoyed customers
Costs of inflation: Relative price variability and misallocation of resources
- no inflation means constant relative prices
- increase in inflation rate means relative prices start off high, then will be low (higher the inflation=greater the automatic variability)
- colonies rely on relative prices to allocate scarce resources
- consumers decide what to buy by comparing quality and prices of goods and services, but if inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources
Costs of inflation: Inflation-induced tax distortions
- lawmakers often fail to take inflation into account in tax laws
- inflation tends to raise the tax burden on income earned from savings
- inflation discourages saving (ex-tax treatment on capital gains, the profits made by selling an asset for more than its purchase price; ex-tax treatment of interest income)
- solution: index the tax system (rewrite tax laws to take into account inflation)
Costs of inflation: Confusion and Inconvenience
- Bank of Canada ensures the reliability of a commonly used unit of measurement (dollar), so when it increases the money supply and creates inflation, it erodes the real value of the unit of account
- accountants incorrectly measure firm’s earnings when prices are rising over time (inflation)
- inflation makes investors less able to sort out successful from unsuccessful firms which then impedes financial markets that allocate the economy’s saving to investment
Costs of inflation: Arbitrary redistributions of wealth
- unexpected inflation redistributes wealth in a way that has nothing to do with merit or need
- ex) unexpected changes in prices redistribute wealth among debtors and creditors; hyperinflation would enrich the debtors (it diminishes the real value of the debt) but a deflation would enrich the creditor (it increases the real value of the debt)
- since inflation is hard to predict, it puts both creditors and debtors at risk they would both like to avoid
- inflation is volatile and uncertain when the average rate of inflation is high
Costs of inflation: inflation is bad, but deflation may be worse
- the Friedman rule: a small and predictable amount of deflation may be desirable since it would lower the nominal interest rate and reduce the cost of holding money, so would require deflation equal to real interest rate
- falling price levels (menu costs)
- deflation comes as a surprise so causes the redistribution of wealth toward creditors and away from debtors (debtors usually poorer so harmful)
- fall in aggregate demand=falling incomes and rising unemployment
- symptom of deeper economic problems
What is the viewpoint “monetarism” and why it was not successful?
- central banks should keep the supply of money growing at a slow constant rate = monetary gradualism
- this policy was adopted due to the problem of inflation in order to try and make it fall
- results: at first, inflation stayed high despite the slowdown in money growth, then inflation fell much more quickly than money growth, so this policy was given up
The policy of inflation targeting is now being used by many of the world’s central banks. How does this policy work?
- central bank sets a target rate of inflation of 2%
- Bank of Canada adjusts monetary policy by changing the overnight rate of interest to stay at this 2% inflation target
- if there is danger of going over 2% inflation, it raises the overnight rate which reduces the growth rate of money supply and reduces future inflation
- other things equal, an increase in money growth will cause an increase in inflation
How does international trade affect the standard of living?
A. It raises the standard of living in all trading countries.
B. It lowers the standard of living in all trading countries.
C. It leaves the standard of living unchanged.
D. It raises the standard of living for importing countries and lowers it for exporting countries.
A. It raises the standard of living in all trading countries.
Country A buys $150 of wine from country B, and B buys $30 of wool from A. Which of the following correctly indicates the two countries’ net exports (in the order A, B)? A. $180 and $0 B. $150 and $30 C. –$120 and $120 D. $120 and –$120
C. –$120 and $120
Sonya, a citizen of Denmark, sells Danish boots and shoes in Canada. Which of the following correctly identifies the effects of these sales on net exports?
A. They increase Canadian net exports and have no effect on Danish net exports.
B. They decrease Canadian net exports and have no effect on Danish net exports.
C. They increase Canadian net exports and decrease Danish net exports.
D. They decrease Canadian net exports and increase Danish net exports.
D. They decrease Canadian net exports and increase Danish net exports.
Which of the following best defines net capital outflow?
A. It is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreign residents.
B. It is the purchase of foreign assets by domestic residents minus the purchase of foreign goods and services by domestic residents.
C. It is the purchase of domestic assets by foreign residents minus the purchase of domestic goods and services by foreign residents.
D. It is the purchase of domestic assets by foreign residents minus the purchase of foreign assets by domestic residents.
A. It is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreign residents.
Which of the following would be Canadian foreign direct investment?
A. A Swedish car manufacturer opens a plant in Sherbrooke, Quebec.
B. A Dutch citizen buys shares of stock in a Canadian company.
C. Tim Hortons, a Canadian company, opens a restaurant in Jamaica.
D. A Canadian citizen buys stock in companies located in Japan.
C. Tim Hortons, a Canadian company, opens a restaurant in Jamaica.
Which of the following would be a Canadian foreign portfolio investment?
A. Nortel, a Canadian company, builds a new factory near Rome, Italy.
B. Your economics professor, a Canadian citizen, buys stock in companies located in Eastern European countries.
C. A Dutch hotel chain opens a new hotel in Canada.
D. A citizen of Singapore buys a bond issued by a Canadian corporation.
B. Your economics professor, a Canadian citizen, buys stock in companies located in Eastern European countries.
Suppose Connie, a Canadian citizen, buys bonds issued by an automobile manufacturer in Sweden. Which of the following would her expenditure be?
A. Canadian foreign direct investment that would increase Canadian net capital outflow
B. Canadian foreign direct investment that would decrease Canadian net capital outflow
C. Canadian foreign portfolio investment that would increase Canadian net capital outflow
D. Canadian foreign portfolio investment that would decrease Canadian net capital outflow
C. Canadian foreign portfolio investment that would increase Canadian net capital outflow
Which of the following shows that any trade transaction must have a financial counterpart? A. NCO = NX B. NCO + I = NX C. NX + NCO = Y D. Y = NCO – I
A. NCO = NX
Suppose Canada sells chocolate to the United States. Which of the following correctly identifies the effects of this transaction?
A. U.S. net exports increase, and U.S. net capital outflow increases.
B. U.S. net exports increase, and U.S. net capital outflow decreases.
C. U.S. net exports decrease, and U.S. net capital outflow increases.
D. U.S. net exports decrease, and U.S. net capital outflow decreases.
D. U.S. net exports decrease, and U.S. net capital outflow decreases.
A Canadian firm opens a factory that produces camping equipment in Albania. Which of the following correctly identifies the effects of this transaction?
A. Canadian net capital outflow increases, and Albanian net capital outflow decreases.
B. Canadian net capital outflow decreases, and Albanian net capital outflow increases.
C. Only Canadian net capital outflow increases.
D. Only Albanian net capital outflow increases.
A. Canadian net capital outflow increases, and Albanian net capital outflow decreases.
A British pharmacy buys drugs from a Canadian company and pays for them with British pounds. Which of the following correctly identifies the effects of this transaction?
A. It increases British net exports and increases Canadian capital outflow.
B. It increases British net exports and decreases Canadian capital outflow.
C. It decreases British net exports and increases Canadian capital outflow.
D. It decreases British net exports and decreases Canadian capital outflow.
C. It decreases British net exports and increases Canadian capital outflow.
Which of the following is the formula for an open economy's GDP? A. Y = C + I + G B. Y = C + I + G + T C. Y = C + I + G + S D. Y = C + I + G + NX
D. Y = C + I + G + NX
Which of the following is the formula for investment in an open economy? A. I = Y – C B. I = S C. I = S – NCO D. I = S + NX
C. I = S – NCO
