Write answers on a printed copy of the homework. Write on one side of a sheet an

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Write answers on a printed copy of the homework. Write on one side of a sheet and staple separate sheets together. Use extra sheet(s) if needed. If you have reason to believe that I shall not be able to read your handwriting, please use a word processor to type your answers. Your answers must be fully explained.

1) Suppose the annual growth rate of real GDP for the nation of Vicuna is 8%, the growth rate of velocity is 0%, and the growth rate of the money supply is 12%.

a. What is the current rate of inflation?

b. What will happen to the inflation rate if the growth of the money supply increases to 16%?

c. What will happen to the inflation rate if the growth of the money supply increases to 16%, and at the same time, the growth rate of velocity increases to 4%?

2) During the 1990s, Japan experienced periods of deflation and nominal interest rates that approached zero percent. Why would anyone lending money agree to a nominal interest rate of almost zero percent?

3) Explain how inflation can be costly even if it is expected.

4) Suppose you deposit $5,000 in cash into your checking account at Wells Fargo Bank. Assume that Wells Fargo Bank has no excess reserves at the time you make your deposit and that the required reserve ratio is 10%. Suppose that Wells Fargo makes the maximum loan they can from the funds you deposited. What is the maximum increase in checking account deposits that can result from your $5,000 deposit? What is the maximum increase in the money supply? Explain.

Explanation / Answer

1. As per quantity theory of money, Growth rate of money + Change in velocity = Inflation + Real GDP growth rate.

a. 12 +0 = I + 8

I = 12-8 = 4% inflation

b. Now Ms = 16%

I = 16 - 8 = 8%

c. Now MS = 16% and V = 4%

16 + 4 = 8 + I

I = 20 - 8 = 12%

3. When we expect inflation or price rise, we start increasing our present consumption. This leads to high aggregate demand suddnely and thus price rise because demand cannot be met immediatley. Thus, expected inflation bring inflation before time.

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