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Which of the following two statements involves positive economic analysis and which Economics 1 — Semester 2 — Tutorial Sheet 8 — Week 9 Money and Inflation in the Long Run Required reading - Recent lecture notes - Nils Gottfries, Macroeconomics, Chapter 7 (Note: it is assumed here and will be assumed in the exam that you are familiar with the terminology laid out on pages xxvi - xxvii of Gottfries’ text.) Homework - Submission of homework this semester works like semester 1, but there is now one additional component – you must also submit a graph. - The submission must be done via Learn by 5pm on the Sunday before the tutorials occur. - The written homework, as before, should be equivalent to at least two sides of handwritten A4 and should be clear enough to read. Again, it does not need to be complete, and indeed it does not even need to be correct. You just need to show that you have made an honest attempt. As long as you have shown an honest attempt, you will get credit, and as long as you do this for 14 of the 18 tutorials during the year, you will get full credit. - NEW FOR SEMESTER 2: you must also submit an additional page with a ‘looking at the data’ graph (this will be different each week, and relevant information will be on each tutorial sheet). Further resources - Gottfries on YouTube: the textbook author (Nils Gottfries) has put 15-40 minute videos from most chapters of the book on YouTube: o https://goo.gl/Wq8o82 - FRED: Most of the tutorial sheets this semester contain graphs generated by the St. Louis Fed’s Federal Reserve Economic Data (FRED) site. This is a surprisingly easy-to-use, free site for exploring hundreds of thousands of economic data series. You are strongly encouraged to visit the site whenever you feel the need to find out what’s happened lately to GDP growth, or inflation, or infant mortality, etc. o http://research.stlouisfed.org/fred2/ Recordings: - Questions marked with an asterisk* have video solutions recorded by Sean, which will be released after the Sunday 5pm submission deadline. Because the asterisk questions are covered in video, they will mostly not be covered within the tutorials themselves. https://goo.gl/Wq8o82 http://research.stlouisfed.org/fred2/ Looking at the data Using FRED (or another data source) find and print a graph of M1 growth and inflation for a country of your choice. Include comments on any trends or features in the data and bring the printed graph and comments to your tutorial. The Bank of England Like all models, the models of money creation in this chapter are simplifications. For a somewhat more in-depth view of how money is created, the Bank of England did a couple of nice articles in their 1st quarterly bulletin of 2014. These are interesting (but not examinable): https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-in-the-modern-economy-an-introduction https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy Tutorial Questions * Q1. Go to the Federal Reserve Economic Data (FRED) site and look up the inflation rates for any three of the G7 economies (Britain, France, Germany, Italy, Japan, Canada and the United States). What similarities do you notice? Can you summarise the history of the G7 inflation rates as a series of three or four stages? * Q2. What is the effect on credit markets of each of the following? Make sure to specify and explain who (if anyone) wins, and who loses. (a) Unexpected inflation (b) Unexpected disinflation (c) Expected inflation (d) Expected disinflation * Q3. Discuss the following statements: (a) “Inflation is destructive.” (b) “Without inflation we would have been much better off.” (c) “Inflation is a tax.” (d) “Without inflation there would be no seignorage for the central bank.” Q4. Which one of these countries do you think had the highest ever monthly inflation rate? (You are encouraged to take a wild guess without looking it up beforehand.) i. China ii. Germany iii. Greece iv. Hungary v. Yugoslavia vi. Zimbabwe Q5. The opportunity cost of holding money is said to be the nominal interest rate. Why is it the nominal rather than the real interest rate? Q6. Discuss whether the following items qualify as ‘money’ in the sense that they have the four characteristics that money has in the theory presented in the textbook: (a) Gold (b) Dollar bills (c) Money in an ISA savings account (d) A credit card (e) Foreign currency (f) Banks’ claims in the payment system (reserves) Q7. (a) What is the monetary base? (b) Is it possible to make purchases without using monetary base? (c) Is it possible to make loans and pay interest without using monetary base? (d) Does the central bank have perfect control of the monetary base? Q8. Give some examples of events that could increase the amount of monetary base needed to make a given amount of transactions. Q9. Discuss how the following may affect the demand for monetary base: (a) Because of high inflation, people start to use foreign currency for large payments. (b) Because of financial uncertainty, banks start to hold more money in their accounts in the payment system. (c) It becomes possible to pay with credit cards on buses and trains. Q10. Consider the following graphs of the US data since 1960 on the price level1 (top left), money supply2 (top right), real output3 (bottom left) and the velocity of money4 (bottom right). Note that US recessions are shaded in grey. When applying the quantity theory of money ?? = ??, or the rule-of-thumb version of it based on growth rates, we often treat velocity as constant in the long run. Is this a reasonable simplification? Are there times when the V-is-constant approximation would have been particularly unhelpful? Q11. The money supply increases 10% in a year. What is the inflation rate if… (a) …real production and velocity are constant (b) …real production grows 4 percent and velocity is constant 1 US. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items [CPIAUCSL], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/CPIAUCSL/, January 1, 2015. 2 Board of Governors of the Federal Reserve System (US), M2 Money Stock [M2SL], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/M2SL/, January 1, 2015. 3 US. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/GDPC1/, January 1, 2015. 4 Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/M2V/, January 1, 2015. (c) …real production is constant and velocity decreases from 2 to 1.8 Q12. We know that ?? = ??. Solving for Y we get ? = ??/? and, using our rule of thumb for growth rates, we have ?? ?⁄ = ?? ?⁄ + ?? ?⁄ − ?? ?⁄ . Apparently, this equation says that inflation will reduce real growth. One percent higher inflation means one percent lower real growth. Is this true or is there any mistake in this argument? (Hint: Think about exogenous and endogenous variables.) * Q13. ‘High inflation is a tax on people who save.’ Is this true or false? * Q14. ‘Higher expected inflation in the future will raise inflation today.’ Is this true or false? If true, clarify the conditions under which the statement may be true. Q15. In 2004 GDP in the USA was $11 876 billion dollars and in 2005 it was $12 718 billion dollars. The monetary base was $759 billion in 2004 and $787 billion in 2005. (a) Calculate the velocity of the monetary base in 2004 and 2005. (b) Calculate seignorage relative to GDP in 2005. (c) Calculate what seignorage would have been if velocity had remained unchanged between 2004 and 2005. (d) Explain the difference between the results in (b) and (c). Q16. Suppose that the velocity of the monetary base is 20, real GDP grows 3% per year and inflation is 2%. (a) Calculate seignorage relative to GDP. (b) Calculate seignorage relative to GDP if the real growth rate is instead 8% and velocity remains unchanged. (c) Calculate seignorage relative to GDP if inflation is instead 7% and velocity remains unchanged. (d) Would you expect velocity to be the same in cases (b) and (c) as in (a)? Consider both the short and the long run. (e) Is the result in (c) an over- or underestimation of the increase in seignorage? Q17. Assume that velocity is determined by the function ? = ?????, where ?? is the ‘base’ velocity, b is a parameter, and t, the nominal interest rate i is determined by ? = ?? + ?, where the natural (real) rate of interest, ??, is taken as given. (a) Write down an expression for seignorage