Question 1

A bank lends money for a year at an interest rate of 7%, and the inflation rate for that year turns out to be 5%. What is the bank's real rate of return for that year?

Accepted Answer

The real rate of return is calculated by subtracting the inflation rate from the nominal interest rate. Here, 7% - 5% = 2%.

Question 2

Which of the following correctly represents unexpected disinflation?

Accepted Answer

Unexpected disinflation occurs when the expected inflation rate (E$\pi$) is greater than the actual inflation rate ($\pi$), meaning inflation was lower than anticipated.

Question 3

The realized real rate of return for lenders is equal to the nominal rate of return:

Accepted Answer

The realized real rate of return for lenders is equal to the nominal rate of return minus the inflation rate. This is because inflation reduces the purchasing power of money, so lenders need to earn a return that is higher than the inflation rate in order to maintain the value of their investment.

Question 4

Money illusion occurs when people:

Accepted Answer

Money illusion occurs when people see changes in nominal prices and mistake them for changes in real prices. They fail to take into account inflation or changes in the purchasing power of money, and instead focus solely on the nominal values. This can lead people to make poor financial decisions or misinterpret economic trends.

Question 5

High volatility in the inflation rate can result in:

Accepted Answer

High volatility in the inflation rate can cause uncertainty and unpredictability in the economy, leading to improper allocation of resources. This can lead to businesses making decisions based on inaccurate or incomplete information, which can result in inefficient production and use of resources. Sudden changes in output or deflation may be symptoms of these underlying issues, but they are not necessarily caused directly by high volatility in inflation. Low volatility in the CPI may imply stability, but it is not necessarily an indicator of proper resource allocation or a healthy economy.

Question 6

Because of money illusion, inflation usually confuses:

Accepted Answer

Money illusion is the tendency of people to think in nominal terms, ignoring the effects of inflation on real purchasing power. This can lead to confusion for consumers, workers, and firms who may not fully understand the impact of inflation on their buying power, wages, and profits. Therefore, the best choice is D.

Question 7

When the money supply and the demand for goods increase at the same time:

Accepted Answer

Both consumers and producers can often become confused when the money supply and the demand for goods increase at the same time because they are receiving mixed signals about the state of the economy. Consumers may be unsure whether to increase their spending or save their money, while producers may be uncertain whether to ramp up production or maintain current levels. This uncertainty can make it difficult for both groups to make informed decisions, potentially leading to market fluctuations and volatility.

Question 8

Use the following to answer questions: Table: Anticipating Inflation $$\begin{array} { l c c } 
\hline \text { Year } & \text { Predicted Inflation Rate } & \text { Actual Inflation Rate } \
\hline 2000 & 3 \% & 3 \% \
2001 & 3 \% & 2 \% \
2002 & 7 \% & 9 \% \
2003 & 5 \% & 4 \% \
2004 & 4 \% & 7 \% \
\hline
\end{array}$$
-(Table: Anticipating Inflation) Using the inflation data in the table above, assume that all loan contracts have fixed nominal interest rates of 10% and mature after 1 year. Which year did borrowers gain relative to lenders?

Accepted Answer

Borrowers gain when actual inflation is higher than predicted because they repay loans with money that is worth less than expected. In 2002, the actual inflation rate (9%) was higher than the predicted rate (7%).

Question 9

Current forecasts say that mild inflation is expected next year. If, however, deflation occurs instead:

Accepted Answer

In a deflationary environment, the real value of money increases. Lenders gain because the money they receive back has more purchasing power, while borrowers lose because they have to repay loans with money that is worth more than when they borrowed it.

Question 10

Use the following to answer questions: Table: Anticipating Inflation $$\begin{array} { l c c } 
\hline \text { Year } & \text { Predicted Inflation Rate } & \text { Actual Inflation Rate } \
\hline 2000 & 3 \% & 3 \% \
2001 & 3 \% & 2 \% \
2002 & 7 \% & 9 \% \
2003 & 5 \% & 4 \% \
2004 & 4 \% & 7 \% \
\hline
\end{array}$$
-(Table: Anticipating Inflation) Using the inflation data in the table above, assume that all loan contracts have fixed nominal interest rates of 10% and mature after one year. Which year did lenders gain relative to borrowers?

Accepted Answer

In 2003, the actual inflation rate (4%) was lower than the predicted inflation rate (5%), meaning lenders gained because the real interest rate was higher than expected.

Question 11

Which of the following correctly represents deflation?

Accepted Answer

Deflation is a decrease in the general price level of goods and services, which is represented by a negative inflation rate ($\pi$ < 0).

Question 12

Lillian loaned A.J. $10,000 and increased her purchasing power by $200 when A.J. repaid the loan a year later. Deflation of 2% also occurred that year. What nominal interest rate did Lillian charge A.J.?

Accepted Answer

The answer of Lillian loaned A.J. $10,000 and increased her...

Question 13

What is the Fisher effect?

Accepted Answer

The Fisher effect is the tendency of nominal interest rates to rise with higher expected inflation rates. This occurs because lenders demand compensation for the expected loss of purchasing power due to inflation, which leads to an increase in nominal interest rates.

Question 14

Lonnie lends Burt $15,000 in 2009. Burt repaid Lonnie $150 in real interest for the 1-year loan. Inflation that year was 1.5%. What nominal interest rate did Lonnie charge Burt?

Accepted Answer

The real interest rate is the nominal interest rate minus the inflation rate. So, the nominal interest rate is the real interest rate plus the inflation rate. In this case, the real interest rate is $150, and the inflation rate is 1.5%. So, the nominal interest rate is $150 + 1.5% = 2.5%.

Question 15

Unanticipated high inflation always means:

Accepted Answer

Unanticipated high inflation erodes the real value of money, meaning that lenders receive less purchasing power back than they lent out, resulting in a loss for them. Borrowers, however, benefit as they repay loans with money that is worth less than when they borrowed it.

Question 16

Use the following to answer questions: Table: Anticipating Inflation $$\begin{array} { l c c } 
\hline \text { Year } & \text { Predicted Inflation Rate } & \text { Actual Inflation Rate } \
\hline 2000 & 3 \% & 3 \% \
2001 & 3 \% & 2 \% \
2002 & 7 \% & 9 \% \
2003 & 5 \% & 4 \% \
2004 & 4 \% & 7 \% \
\hline
\end{array}$$
-(Table: Anticipating Inflation) Using the inflation data in the table above, assume that all loan contracts have fixed nominal interest rates of 10% and mature after 1 year. In which year did lenders receive exactly the amount of real interest they expected?

Accepted Answer

In 2000, the predicted inflation rate was 3% and the actual inflation rate was also 3%. This means that the real interest rate was 10% - 3% = 7%, which is exactly what lenders expected.

Question 17

When changes in nominal prices are confused with changes in real prices, people experience:

Accepted Answer

The term for confusing nominal prices with real prices is called "money illusion." This happens when people focus on nominal prices (the face value of a good or service) instead of real prices (the value of a good or service adjusted for inflation). Money illusion can lead to mistaken perceptions of changes in purchasing power and can affect economic decision-making.

Question 18

When people suffer from money illusion, an increase in the money supply:

Accepted Answer

When people suffer from money illusion, they tend to focus on nominal values rather than real values. Therefore, an increase in the money supply will increase nominal GDP in the short run, leading to an increase in real GDP due to the misperception that real incomes have risen. However, in the long run, wages and prices adjust to the increased money supply, and the economy returns to its original equilibrium level of output.

Question 19

Jordan loaned Taylor $1,200 on March 15, 2009. Taylor returned $1,260 on March 14, 2010. Inflation was 2% over the 1-year period. What is the real interest rate that Taylor paid?

Accepted Answer

The answer of Jordan loaned Taylor $1,200 on March 15,...

Question 20

Which of the following is an example of money illusion assuming that inflation is 5%?

Accepted Answer

Money illusion occurs when individuals focus on nominal wages or prices instead of real wages or prices adjusted for inflation. In this scenario, the individual received a 5% raise, but if inflation is also 5%, their real wage did not increase. However, they are assuming that they have more money to spend and are increasing their entertainment expenses, indicating they are falling for the money illusion.

Quiz 12: Inflation and the Quantity Theory of Money