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**The level of prices and the value of money**

Suppose the price level reflects the number of dollars needed to buy a basket of goods containing one cup of tea, one biscuit, and one magazine. In year one, the basket costs $10.00.

In year two, the price of the same basket is $9.00. From year one to year two, there is _______ at an annual rate of ______.

In year one, $50.00 will buy ______ baskets, and in year two, $50.00 will buy _____ baskets.

This example illustrates that, as the price level falls, the value of money ______.

**Money supply, money demand, and adjustment to monetary equilibrium**

The following table shows a money demand schedule, which is the quantity of money demanded at various price levels (P).

*Fill in the Value of Money column in the following table.*

Price Level (P) | Value of Money (1/P) | Quantity of Money Demanded |

(Billions of dollars) | ||

1.00 | 2.0 | |

1.33 | 2.5 | |

2.00 | 4.0 | |

4.00 | 8.0 |

Now consider the relationship between the price level and the quantity of money that people demand. The lower the price level, the ____ money the typical transaction requires, and the ______ money people will wish to hold in the form of currency or demand deposits.

Assume that the Fed initially fixes the quantity of money supplied at $2.5 billion.

*Use the orange line (square symbol) to plot the initial money supply (*MS1MS1*) set by the Fed. Then, referring to the previous table, use the blue connected points (circle symbol) to graph the money demand curve.*

According to your graph, the equilibrium value of money is _______, therefore the equilibrium price level is ______.

Now, suppose that the Fed increases the money supply from the initial level of $2.5 billion to $4 billion.

In order to increase the money supply, the Fed can use open market operations to _____ the public.

*Use the purple line (diamond symbol) to plot the new money supply (*MS2*).*

Immediately after the Fed changes the money supply from its initial equilibrium level, the quantity of money supplied is ______ than the quantity of money demanded at the initial equilibrium. This expansion in the money supply will _____ people’s demand for goods and services. In the long run, since the economy’s ability to produce goods and services has not changed, the prices of goods and services will _____ and the value of money will ______.

**The classical dichotomy and the neutrality of money**

The **classical dichotomy** is the separation of real and nominal variables. The following questions test your understanding of this distinction.

Eileen spends all of her money on magazines and donuts. In 2013, she earned $27.00 per hour, the price of a magazine was $9.00, and the price of a donut was $3.00.

Which of the following give the **nominal** value of a variable?* Check all that apply.*

The price of a donut is 0.33 magazines in 2013.

Eileen’s wage is 3 magazines per hour in 2013.

The price of a donut is $3.00 in 2013.

Which of the following give the **real** value of a variable?* Check all that apply.*

The price of a magazine is $9.00 in 2013.

Eileen’s wage is $27.00 per hour in 2013.

The price of a magazine is 3 donuts in 2013.

Suppose that the Fed sharply increases the money supply between 2013 and 2018. In 2018, Eileen’s wage has risen to $54.00 per hour. The price of a magazine is $18.00 and the price of a donut is $6.00.

In 2018, the relative price of a magazine is ______.

Between 2013 and 2018, the nominal value of Eileen’s wage _______, and the real value of her wage _____.

Monetary neutrality is the proposition that a change in the money supply _____ nominal variables and ______ real variables.

**Velocity and the quantity equation**

Consider a simple economy that produces only cell phones. The following table contains information on the economy’s money supply, velocity of money, price level, and output. For example, in 2019, the money supply was $240, the price of a cell phone was $7.20, and the economy produced 500 cell phones.

*Fill in the missing values in the following table, selecting the answers closest to the values you calculate.*

Year | Quantity of Money | Velocity of Money | Price Level | Quantity of Output | Nominal GDP |

(Dollars) | (Dollars) | (Cell phones) | (Dollars) | ||

2019 | 240 | 7.20 | 500 | ||

2020 | 252 | 15 | | 500 | |

The money supply grew at a rate of _____ from 2019 to 2020. Since cell phone output did not change from 2019 to 2020 and the velocity of money ____, the change in the money supply was reflected ______ in changes in the price level. The inflation rate from 2019 to 2020 was ______.

**Using money creation to pay for government spending**

Consider Kharkeez, a hypothetical country that produces only burgers. In 2016, a burger is priced at $4.00.

*Complete the first row of the table with the quantity of burgers that can be bought with $300.*

**Hint**: In this problem, assume it is not possible to buy a fraction of a burger, and always** round down** to the nearest whole burger. For example, if your calculations result in 1.5 burgers, the answer should be 1 burger.

Year | Price of a Burger | Burgers Bought with $300 |

(Dollars) | (Quantity) | |

2016 | 4.00 | |

2017 |

Suppose the government of Kharkeez cannot raise sufficient tax revenue to pay its debts. In order to meet its debt obligations, the government prints money. As a result, the money supply rises by 20% by 2017.

*Assuming monetary neutrality holds, complete the second row of the table with the new price of a burger and the new quantity of burgers that can be bought with $300 in 2017.*

The impact of the government’s decision to raise revenue by printing money on the value of money is known as the _____.

**The Fisher effect and the cost of unexpected inflation**

Suppose the nominal interest rate on savings accounts is 11% per year, and both actual and expected inflation are equal to 5%.

*Complete the first row of the table by filling in the expected real interest rate and the actual real interest rate before any change in the money supply.*

Time Period | Nominal Interest Rate | Expected Inflation | Actual Inflation | Expected Real Interest Rate | Actual Real Interest Rate |

(Percent) | (Percent) | (Percent) | (Percent) | (Percent) | |

Before increase in MS | 11 | 5 | 5 | ||

Immediately after increase in MS | 11 | 5 | 6 |

Now suppose the Fed unexpectedly increases the growth rate of the money supply, causing the inflation rate to rise unexpectedly from 5% to 6% per year.

*Complete the second row of the table by filling in the expected and actual real interest rates on savings accounts immediately after the increase in the money supply (MS).*

The unanticipated change in inflation arbitrarily **benefits _____**.

Now consider the **long-run** impact of the change in money growth and inflation. According to the Fisher effect, as expectations adjust to the new, higher inflation rate, the nominal interest rate will _____ to _____% per year.

**Identifying costs of inflation**

Hubert manages a grocery store in a country experiencing a high rate of inflation. He is paid in cash twice per month. On payday, he immediately goes out and buys all the goods he will need over the next two weeks in order to prevent the money in his wallet from losing value. What he can’t spend, he converts into a more stable foreign currency for a steep fee. This is an example of the ___ of inflation.

**Inflation-induced tax distortions**

Dmitri receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest rate of 4.5% per year. The nominal interest rate on the bonds adjusts automatically to account for the inflation rate.

The government taxes **nominal** interest income at a rate of 10%. The following table shows two scenarios: a low-inflation scenario and a high-inflation scenario.

*Given the real interest rate of 4.5% per year, find the nominal interest rate on Dmitri’s bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario.*

Inflation Rate | Real Interest Rate | Nominal Interest Rate | After-Tax Nominal Interest Rate | After-Tax Real Interest Rate |

(Percent) | (Percent) | (Percent) | (Percent) | (Percent) |

2.0 | 4.5 | |||

8.5 | 4.5 |

Compared with lower inflation rates, a **higher** inflation rate will _____ the after-tax real interest rate when the government taxes **nominal** interest income. This tends to _____ saving, thereby _____ the quantity of investment in the economy and _____ the economy’s long-run growth rate.