1. The misery index is the sum of the inflation and unemployment rates. A criticism is that it weights one percentage point of inflation as equal to one percentage point of unemployment, whereas the costs of one percentage point of inflation and unemployment are unsettled issues and are not likely to be equal.
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2. A hyperinflation is a very rapid rate of inflation; Gordon defines it as at least 1,000 percent per year. A moderate (or creeping) inflation, on the other hand, implies a ˇ§moderateˇ¨ rate of inflation, presumably an inflation rate less than 1,000 percent per year.
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3. Yes, simple percentage changes are misleading as measures of inflation at high rates inflation; in particular, they overstate the rate of inflation. If inflation is a continuous process (i.e., prices rising daily of even hourly, as in a hyperinflation), calculating inflation rates at discrete intervals (such as months, quarters, or years) may be misleading. As Gordon says in footnote 1, a simple percentage rate of change at 50 percent per month compounds to an annual rate of 12,875 percent, whereas the very same implied absolute price increase when compounded continuously produces an inflation rate of 40.5 percent per month or 487 percent per year. End-of-chapter Problems 1 and 2 also deal with this issue.
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4. Excess nominal GDP growth relative to natural real GDP growth is simply the difference between nominal GDP growth and natural real GDP growth, or x - yN. It is equal to the inflation rate when actual real GDP growth is equal to natural real GDP growth, or when y - yN = 0. (See footnote 4.)
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5. The four main reasons for inflation are the temptation of demand stimulation to reduce unemployment, the fear of the recession and job loss needed to reduce inflation, an adverse supply shock, and financing government deficits by printing money.
The temptation to reduce unemployment results in an excessive growth rate of nominal GDP because in the short run, the excessive growth does result in an increase in the output ratio and therefore a decline in the unemployment rate. It is only in the long run that the excessive growth results in no change in the unemployment rate.
A permanent reduction in inflation requires a reduction in the growth rate of nominal GDP. That reduction results in a recession in the short run as the output ratio falls and the unemployment rate rises. It is the fear of that recession which often results in excessive nominal GDP growth and inflation.
If there is an adverse supply shock, then even in the short run inflation rises unless nominal GDP growth is reduced via an extinguishing policy.
Finally, government deficits are often financing by printing money or increasing the money supply, particularly if countries do not have well developed financial markets in which the government can sell its bonds. Also recall from Chapter 6 that in a small open economy with a fixed exchange-rate system, a fiscal expansion must result in an increase in the money supply. Therefore that fiscal expansion results in excessive nominal GDP growth no matter how well developed the economyˇ¦s financial markets are.
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6. The nominal interest rate (i) is the rate actually paid in the financial markets. The expected real interest rate (re = i - pe) is what people expect to pay on borrowings or earn on their savings after deducting expected inflation. The actual real interest rate (r = i - p) is what people actually pay or earn after taking into account the actual inflation rate. The rate that people expect to exist affects their borrowing and saving decisions, and the actual real interest rate determines what people actually pay or earn.
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7. In an
unanticipated inflation, whether a person is a net debtor or net creditor
determines whether he wins or loses. Net debtors gain because their debts shrink
in real terms, while their real and financial assets are not indexed for
inflation. Wealthy individuals are net creditors, so they tend to lose.
Middle-income homeowners and farmers are net debtors; they own assets that can
vary in price
(e.g., homes and land) and debts that are fixed in nominal terms (e.g.,
mortgages), so they tend to gain. The poor are neither net creditors nor net
debtors because they neither save nor borrow much. They donˇ¦t save for obvious
reasons, and they canˇ¦t borrow because they lack collateral. Poor people near
retirement who rely entirely on Social Security are protected by the indexation
of Social Security benefits.
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8. The nominal interest rate
(a) falls;
(b) rises;
(c) falls;
(d) falls.
9. The Fisher equation states that the nominal interest rate is the sum of the expected real rate of interest and the expected inflation rate. The Fisher Effect states that the nominal interest rate changes by the same number of percentage points that the expected rate of inflation changes.
The Fisher
equation is true by its definition, whereas the Fisher Effect is a testable
hypothesis.
Figure 9.1 shows that in the period 1975ˇV76, the rise in the nominal interest
rate was much less than the rise in the expected rate of inflation, whereas in
the early 1980s, the rise in the nominal interest rate was much larger than the
rise in the expected rate of inflation. Figure 9.1 also shows that between 1983
and 1985 the nominal interest rate rose during a period when the expected
inflation rate was falling and that during the early 1990s the decline in the
nominal interest rate was much larger than the decline in the expected rate of
inflation. Therefore the data presented in Figure 9.1 refute the Fisher Effect.
The graph in
the box on page 294 shows that the gap between real and nominal interest rates
on
10-year Treasury bonds widened considerably starting in early 2002. This could
be consistent with the Fisher Effect if at the same time the real interest rate
were falling, expected inflation was rising. But falling real interest rates
typically are associated with a weakening economy, which would lead to a lower,
not a higher inflation rate. The other explanation of a falling real interest
rate and a stable nominal interest rate that is consistent with a Fisher Effect
is that the TIPS Bonds were overbought. But if that were the case, then the
return on the un-indexed bonds would have been high relative to the indexed
bonds, which should have resulted in a narrowing of the prices and therefore the
two interest rates on the two types of bonds. The data in the box do not show
that happening. Therefore, the data in the box on page 294 do not provide
support for the Fisher Effect.
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10. If real interest income is taxed whereas nominal interest expense is allowed to be deducted, then the tax laws are subsidizing borrowing in the sense that borrowers are paying less after taxes than lenders are receiving. That results in too much borrowing, not enough saving, and too much spending.
11. In equation (12.9), the left-hand side represent governmental expenditures. It consists of the real ˇ§basic deficit,ˇ¨ i.e., G - T, or real government expenditures on goods and services minus real net taxes (taxes minus transfers), plus real interest payments on government bonds outstanding. The right-hand side represents government revenue sources (exclusive of T, which is subtracted from G on the left-hand side). It consists of the real value of new bond issues and the real value of new issues of high-powered money.
12. The conditions for a ˇ§steady stateˇ¨ are that nominal government bonds, B, nominal high-powered money, H, and the price level, P, all grow at the same rate. This implies that real government bonds, B/P, and real high-powered money, H/P, are constant. If this is so, then the government budget constraint can be written as Equation (12.12). This equation shows that the government benefits from inflation in two ways. First, when the government raises the amount of high-powered money, it receives revenue called seignorage or the inflation tax. Second, when the government raises the amount of real bonds outstanding, it pays only real, rather than nominal, interest on its bonds; in addition, if the nominal interest rate does not rise one percentage point for every percentage-point increase in inflation, then the real interest rate falls, and the government gains by financing its debt with a lower real interest rate.
13. The deficit must be financed by either an increase in the government debt held by the public or an increase in the government debt held by the Fed (which results in the creation of high-powered money). If the economy starts at YN and there is no change in monetary policy, then the increase in high-powered money would lead to increased growth in the money supply and in nominal GDP, which would be inflationary. If the government adjusted its monetary policy and kept the growth of nominal GDP constant, however, there would be no inflationary pressures.
14. A mild inflation can be converted into a hyperinflation by frequent wage indexation. Wage indexation leads to wage increases, which set off further price increases. At a given exchange rate, price increases will reduce the demand for the countryˇ¦s exports. The reduced demand for exports will reduce the demand for the countryˇ¦s currency, which will cause a depreciation in the exchange rate. A decrease in the exchange rate will raise the domestic-currency price of imports, which acts as a supply shock and further exacerbates inflation.
15. To stop a hyperinflation, a government should do several or all of the following depending on its circumstances: reduce its budget deficit, by cutting its expenditures and transfers and by raising taxes; reduce the growth of the money supply; reform its tax system if tax evasion is a problem and if there is no broad-based tax that is easy to collect, such as a value-added tax; stop or slow wage increases by mandating a wage freeze, introducing a wage control policy, or reducing the frequency of indexation; seek an international agreement to suspend interest payments on its international debt; move from a flexible exchange rate to a fixed exchange rate.
16. Each dollar gives certain advantages, such as purchasing convenience, to the holder; these advantages are called extra convenience services (ECS). Holding a dollar, however, means that an individual is foregoing the interest he could be earning. A rational individual would hold money only until the last dollar held gives ECS greater than or equal to the nominal interest rate. If an expected inflation occurs and the nominal interest rate rises, people will give up holding some amount of money for which the ECS is less than the nominal interest rate. As a result, society is ˇ§losingˇ¨ the extra convenience services of this additional amount of money.
17. No. Expansionary monetary policy would increase the ratio, Y/YN, and therefore lower actual unemployment. This will have no effect on the natural rate of unemployment, however. The natural rate of unemployment is sensitive to long‑run, supply-oriented policies.
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18. If workers do
not have the necessary skills, they do not know about vacancies, or they are not
in the correct geographic locations, they can remain unemployed even while
vacancies exist. If policymakers follow an expansionary policy, output will
increase, requiring more workers. If the labor supply is fixed, the number of
unemployed workers will decrease. If the labor supply increases (e.g., due to an
influx of previously ˇ§discouragedˇ¨ workers), the total number of unemployed
could actually increase. Eventually, however, continued expansionary policy will
lead to a decrease in unemployed workers. Expansionary policy will also lead to
an increase in the number of vacancies.
It is likely that the increased demand for some types of goods will not be
filled due to a shortage of workers who can produce that type of good.
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19. As real output increases, there occur serious shortages of labor in some occupations or in some geographic locations. These shortages cause wage rates to be bid up. A continuing expansion causes these shortages to become relatively more severe and wages to rise at a relatively faster rate.
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20. If the worker faces turnover unemployment, that worker can find a suitable job in the local community after a relatively short ˇ§job search.ˇ¨ On the other hand, if the worker faces mismatch unemployment, that worker may have to be retrained or move to another location. In this case, the time before work is found will be much longer.
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21. Turnover unemployment is due to people who have quit their jobs, or are re-entering the labor force, or are looking for their first jobs. People who quit their jobs do so because they feel they are better off spending their time looking for what they hope will be a better job rather than working at their current job. Similarly people who re-enter the work force do so because they feel they will be better off working than continuing to do whatever it was they were doing while they were out of the work force. Similarly, people who enter the work force for the first time do so because they feel they will be better off working than continuing to do whatever they were doing prior to entering the workforce. To summarize, the benefits of turnover unemployment are that people spend time searching for jobs that will result in a better use of their time than previously.
A mismatch of skills requires that people first acquire skills that are in demand and then find particular employers that need the new skills the people have acquired. That may or may not require people to relocate. On the other hand, the problem of mismatch of location ˇ§simplyˇ¨ requires that people find particular employers in a new location that need the skills that they already have. Thus at the conceptual level, the problem of mismatch of location is less severe than the mismatch of skills. The complicating factor is that a person who needs to acquire new skills may be able to do so without relocating his or her family. On the other hand, if a family must relocate, then the problem of overcoming a mismatch of location could be quite high if a spouse must find a new job and/or children must give up old friends and schools and find new ones.
Being able to use the Internet to obtain information concerning employment opportunities reduces the cost of searching for a new job, particularly a job in a distant geographical area. That results in a reduction in the amounts of turnover unemployment and unemployment due to a mismatch of location. The only possible way that the Internet could reduce the amount of unemployment due to a mismatch of skills is if people are able to obtain better information concerning which skills are most in demand via the Internet. If so, then they might be able to find a job more quickly once they have acquired those new skills.
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22. If the natural rate of unemployment were to fall, then in the absence of a supply shock, monetary authorities would notice that the inflation rate would either continue to fall or start to fall at an unemployment rate at which the monetary authorities would have expected the rate of inflation to stabilize.
Similarly, if the growth rate of natural real GDP were to increase, then in the absence of a supply shock, monetary authorities would notice that the inflation rate would either continue to fall or start to fall at a growth rate of actual real GDP at which the monetary authorities would have expected the rate of inflation to stabilize.
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