Question

QUESTION 2

[100 marks]

What is inflation? According to the quantity theory of money, what causes inflation?                                                                                         [10 marks]

List and explain three types of costs associated with high levels of inflation in an economy.                                                                            [15 marks]

Explain, with the aid of a diagram, how monetary equilibrium determines the price level in an economy, and the value of money.              [20 marks]

Explain the terms systemic risk and macroprudential policy. Give an example of a macroprudential policy that has been implemented in Ireland to reduce systemic risk.                                                                         [20 marks]

What is a bond? Explain how a bank can change the money supply by buying or selling bonds. What is this policy tool called?              [20 marks]

The central bank does not have perfect control of the money supply. Explain why.                                                                                          [15 marks]

Answer 1

• explain how an increase in the price level affects the real value of money?
• Inflation directly reduces the purchasing power that money seems to have in the sense that a given amount of money is not able to buy the same proportions of goods after the price rise. Hence, a reduction in money’s power of purchasing results in the loss of its value.
• according to the quantity theory of money, what is the effect of an increase in the quantity of money
• The theory suggests that velocity of money and real output are unaffected with an increase in supply of money so that all the increase is proportionately translated in increasing the price level The theory relates these variables as P x Y = v x M
• in what sense is inflation like a tax? how does thinking about inflation as a tax help explain hyperinflation?
• Inflation tax is the reduction in the value of money held by the public when government indulges in seigniorage and increases money supply to cover its deficit. When the government prints money too often it tends to raise inflation more frequently and this causes hyperinflation
• according to the fisher effect, how does an increase in the inflation rate affect the real interest rate and the nominal interest rate?
• Observe the Fisher equation and note the nominal interest rate is equal to the natural interest rate plus the current inflation rate . An increase in inflation rate will then reduce the real interest rate if nominal rate is kept fixed.
• what are the costs of inflation? Which of these costs do you think are most important for the U.S. economy?
• Inflation directly reduces the purchasing power that money seems to have in the sense that a given amount of money is not able to buy the same proportions of goods after the price rise. Hence, a reduction in money’s power of purchasing results in the loss of its value.

• It hurts a significant section of the society, particularly the lower income class and the retirees. Another consequence of inflation is its distortionary impact on the spending pattern. People change their priorities while consuming and hence, postpone their buying decisions. Inflation also distorts the pattern of income distribution when it hurts the creditors more than the debtors.

• People with fixed incomes also face the same situation of losing their money when inflation erodes their purchasing power. Inflation also encourages speculation as people start purchasing luxury condominiums, not for residential purposes, but for the purpose for reselling it to another buyer at further higher prices. This tendency has been targeted as one of the major reasons for the sub-prime crisis in 2007-08. This cost is supereme for the US.

• if inflation is less than expected, who benefits debtors or creditors? Explain please
• Inflation distorts the pattern of income distribution when it hurts the creditors more than the debtors. When creditors fund a debt to debtors, they wish to recover an inflation-free interest from them that act as a reward for lending their money. This is the required sentence for the case. In case inflation is less than expected, creditors are at benefit because they receive more money in nominal terms and debtors are hurt.