Question 1

If L.L.Bean decides to increase its prices due to general inflation, it must reprint the millions of catalogs it has already produced and distributed. The costs associated with recreating these catalogs would be classified as:

Accepted Answer

Menu costs refer to the expenses businesses incur when they need to change their prices, such as reprinting menus, catalogs, or price lists, due to inflation or other reasons.

Question 2

The time, money, and effort one spends managing cash in the face of inflation is referred to as:

Accepted Answer

Shoe-leather costs refer to the time, money, and effort expended by individuals and firms in managing their cash balances in the face of inflation. This includes the cost of frequent trips to the bank, keeping smaller cash balances, and utilizing other financial instruments to avoid the negative effects of inflation. Therefore, A is the correct answer. Menu costs refer to the cost of adjusting prices in response to inflation, tax distortions refer to the ways taxes can impact economic activity, and the velocity of inflation measures the rate at which money circulates through the economy.

Question 3

Suppose the annual nominal interest rate is 10percent and the inflation rate is 6 percent. If you deposit $1,000, at the end of the year:

Accepted Answer

The nominal interest rate is 10%, so a $1,000 deposit will earn $100 in interest, making statement C true. The real rate of return adjusts for inflation, calculated as approximately the nominal rate minus the inflation rate (10% - 6% = 4%), making statement A true. Since the real rate of return is positive, your purchasing power increases, making statement B true. Therefore, all statements are true.

Question 4

The real interest rate is:

Accepted Answer

The real interest rate is adjusted for inflation, which means it takes into account the impact of rising prices on the purchasing power of the money being earned or borrowed. Option A is incorrect because the federal funds rate is the rate at which banks lend funds to each other overnight and is set by the Federal Reserve, while the real interest rate is influenced by inflation and other market forces. Option C is partially correct but does not account for inflation. Option D is also incorrect because the actual average interest rate in the economy can be influenced by many factors beyond inflation, such as economic growth and monetary policy.

Question 5

Unpredictable inflation can lead businesses to:

Accepted Answer

Unpredictable inflation makes it difficult for businesses to plan for the future since they don't know what prices they will be paying for their inputs, what their competitors will be charging, or how much demand there will be for their products. This uncertainty can make it challenging to make decisions about how much to produce, what to charge, and what resources to invest in. Restricting output or stockpiling inventory may not be viable options, as it can lead to increased costs and decreased profits. Rather, businesses may have to adjust their production processes to accommodate the changing prices of their inputs and outputs.

Question 6

The money, time, and opportunity used to change prices to keep pace with inflation are called:

Accepted Answer

The money, time, and opportunity costs used to change prices to keep pace with inflation are known as menu costs. This includes the cost of reprinting catalogs, updating price lists and websites, and communicating price changes to customers. These costs are incurred by businesses in response to inflation and are collectively known as menu costs.

Question 7

If the real rate of return is 3 percent and the inflation rate is 4 percent, the nominal interest rate is:

Accepted Answer

The nominal interest rate is equal to the sum of the real rate of return and the inflation rate. 
Nominal interest rate = real rate of return + inflation rate
= 3% + 4%
= 7%

Question 8

Brian is paid monthly via a direct deposit into an interest-bearing checking account. He withdraws $500 of this pay in cash at the beginning of the month to spend throughout it. However, due to recent inflation, Brian decides to instead withdraw $125 from the bank every week, so that his money can earn interest for as long as possible. The time and energy Brian spends visiting the bank more often would be classified as a:

Accepted Answer

Brian is incurring extra time and energy (and possibly transportation costs) to visit the bank more frequently to withdraw smaller amounts of cash. This is known as a shoe-leather cost, which is a type of cost that arises due to inflation and encourages people to reduce their cash holdings by making more frequent withdrawals from their bank accounts.

Question 9

Tax distortions happen because tax laws only take _______ into consideration.

Accepted Answer

Tax distortions often occur because tax laws typically consider nominal income, not adjusting for inflation or changes in purchasing power, which can lead to inequities and inefficiencies in the tax system.

Question 10

If the real rate of return is 5 percent and the inflation rate is 2 percent, the nominal interest rate is:

Accepted Answer

The nominal interest rate is the sum of the real rate of return and the inflation rate. Therefore, the nominal interest rate is 5% + 2% = 7%.

Question 11

Suppose the annual nominal interest rate is 4 percent and the inflation rate is 5 percent. If you deposit $1,000, at the end of the year:

Accepted Answer

The nominal interest rate is the rate at which your money will grow without accounting for inflation. With a 4% nominal interest rate, a $1,000 deposit will earn $40 over the year, making statement C correct. Statements A and B are incorrect because the real rate of return, which accounts for inflation, is actually negative in this scenario (-1%), and thus, purchasing power decreases, not increases.

Question 12

What is the nominal interest rate?

Accepted Answer

The nominal interest rate is the stated interest rate on a loan or investment, without adjusting for inflation. It is the rate that banks charge borrowers or pay to savers.

Question 13

Being penalized for earning a higher dollar amount even though your purchasing power hasn't changed is known as:

Accepted Answer

Tax distortion occurs when an individual's tax liability increases as their nominal income increases, even if their real income and purchasing power remain the same. This can create disincentives to work harder or earn more, leading to inefficiencies in the economy.

Question 14

Suppose the annual nominal interest rate is 10 percent and the inflation rate is 4 percent. If you deposit $1,000, at the end of the year you'll have earned a real rate of interest of:

Accepted Answer

The real rate of interest is the nominal rate minus the inflation rate, which in this case is 10% - 4% = 6%. Therefore, the answer is B) 6%.

Question 15

If the value of your savings is increasing over time, it must be true that the inflation rate:

Accepted Answer

If the value of savings is increasing, it means that the nominal interest rate is greater than the inflation rate. Therefore, the inflation rate is lower than the nominal interest rate.

Question 16

To calculate the real interest rate, we:

Accepted Answer

The real interest rate is the nominal interest rate minus the rate of inflation. This is because the nominal interest rate represents the rate at which money grows over time, but inflation reduces the purchasing power of that money. Therefore, to calculate the true growth rate of money, we need to adjust for inflation by subtracting it from the nominal interest rate.

Question 17

Khiem earns $50,000 per year and pays an annual income tax of 10 percent. Due to an inflation rate of 10 percent, his pay increases to $55,000, which puts him in a higher tax bracket where he must now pay 20 percent. Khiem has experienced:

Accepted Answer

Khiem has experienced the inflationary cost of tax distortion because his increased income has put him in a higher tax bracket, resulting in him paying a higher percentage of his income as tax. This means that he has not fully benefited from the increase in his nominal income due to inflation.

Question 18

Subtracting the inflation rate from the nominal rate of interest gives us the:

Accepted Answer

Subtracting inflation from the nominal interest rate gives us the real interest rate, which is the actual rate of return an investor earns after accounting for inflation.

Question 19

Suppose the annual nominal interest rate is 7 percent and the inflation rate is 7 percent. If you deposit $1,000, at the end of the year:

Accepted Answer

When the nominal interest rate equals the inflation rate, the real interest rate (which adjusts for inflation and reflects the change in purchasing power) is effectively zero. This means that while the nominal amount of money increases due to interest, its purchasing power remains the same because the inflation rate has eroded the value of money at the same rate as the interest has increased it.

Question 20

If the nominal interest rate is higher than the inflation rate, the value of your savings:

Accepted Answer

When the nominal interest rate is higher than the inflation rate, the value of your savings will increase in real terms as the interest earned will be greater than the decrease in purchasing power due to inflation.

Quiz 16: Inflation