Question

Grab a blank sheet of paper and try some inflation analysis on your own. Take a picture or scan your sheet, and upload it after you are finished. This contributes to your participation grade in the class.

1. Because inflation increased by only 1.7% in 2008, the American Association of Retired Persons comments that this is “an unfortunate side effect of inflation, since Social Security payments, which are indexed to inflation, will increase by only 1.7% in 2008.” Comment on whether this is an “unfortunate side effect of inflation” or not.
2. The Federal Reserve Bank (Fed) can impact the economy through changes in the Federal funds rate, because changes in this interest rate will change all interest rates throughout the economy. The Federal funds rate was constant at 5.25% from 1996–1998, a time of falling inflation. What impact did this have on real interest rates during this time? What was likely to happen to investment spending?
3. “Traveling in Turkey is much cheaper now than it was 10 years ago,” says a friend. "Ten years ago, a dollar bought 1,000 lira; this year, a dollar buys 1,500 lira.” Total inflation over this period was 25% in the United States and 100% in Turkey. Is your friend right or wrong—has it become more or less expensive to travel in Turkey?

Upload your file below. Naming convention should be "Last Name_First Name."

Answer 1

a) this is not the unfortunate side because if inflation would have increased then prices would also be higher hence keeping the real income constant only.

b)

• according to Fisher equation,
  • Nominal interest rate is approximately equal to real interest rate + inflation : i = r + π
  • So if inflation is falling and nominal interest rate is constant --> real interest rate will increase.
• Investment spending - Because real interest rate has increased --> borrowing credit has become more expensive --> investment decrease

c) RER = (e*Pf)/Ph

• RER is real exchange rate, Pf is price of foreign country, Ph is price price of home country
• Let's assume without inflation price = 100. So After inflation Pf = 125 and Ph = 200.
• RER = (1500*125)/200 = 937.5
• This means now $1 can buy 937.5 lira only as compared to 1000 earlier --> going to tira has actually become expensive

Note : for simplicity of calculatioms, I have assumed turkey to be home country and US as foreign country. It won't change the results anyways.