Economics 302
Spring 2005
Practice Questions 3 on Chapter 4

Multiple Choice:

1.	The money supply decreases when
a.	The Federal Reserve purchases T-bills in the open market.
b.	The FOMC sells T-bills in the open market.
c.	An individual writes a check to make a purchase.
d.	An individual purchases newly issued stock from a corporation.

2.	Which of the following statements is true?
a.	The U.S. one dollar bill is a good example of commodity money since it is backed by the gold stored at the New York District Federal Reserve Bank.
b.	M3 provides a good measure of the money supply since it includes only those assets that are used to make transactions.
c.	Fiat money has no intrinsic value.
d.	The U.S. Treasury can legally print money and therefore controls the money supply.

3.	A good approximation of the real interest rate is
a.	The nominal interest rate plus the expected inflation rate.
b.	The expected inflation rate minus the nominal interest rate.
c.	The nominal interest rate minus the expected inflation rate.
d.	The sum of one plus the nominal interest rate multiplied by the expected inflation rate.

4.	The Fisher Effect tells us that an increase in the nominal interest rate is due to 
a.	Increases in the real interest rate.
b.	Decreases in the real interest rate.
c.	Decreases in the expected inflation rate.
d.	Increases in the expected inflation rate.

5.	Unanticipated inflation hurts
a.	People on fixed incomes.
b.	Borrowers.
c.	Lenders.
d.	All of the above.
e.	(a) and (b)
f.	(a) and (c)

6.	Compute the transactions velocity of money from the following information.  In the economy under consideration there is only one good, peanuts.  In a given year 2000 pounds of peanuts are sold at $1.00 per pound and the quantity of money in this economy is $200.  The transactions velocity of money is 
a.	1
b.	10
c.	100
d.	.1
e.	1000

7.	Suppose the money supply increases by 5% while the income velocity of money increases by 8% during a given year.  According to the quantity equation, nominal income increased by 
a.	5%
b.	8%
c.	9%
d.	13%

8.	Use the same information in question (7).  In addition you now know that real output increased by 4% during the given year.  The inflation rate for this year is approximately equal to 
a.	9%
b.	8%
c.	5%
d.	4%

9.	Suppose you are using a Classical Model and are told that the money supply increased by 2% in one year and then was held constant at this new, higher level from this point on.  Using the Quantity Theory the inflation rate will
a.	Increase by 2% the first year and each subsequent year.
b.	Increase by 2% the first year and then return to its initial value in subsequent years.
c.	Remain constant at its current level.
d.	Decrease by 2% since there is more money available in the economy.

10.	Suppose you know the nominal interest rate is 6% and you expect inflation to be 4%.  Actual inflation ends up being 3%.  Which of the following statements is true?
a.	The ex post real interest rate is 6%.
b.	The ex post real interest rate is 2%.
c.	The ex post real interest rate is 3%.
d.	The ex ante real interest rate is 6%.
e.	The ex ante real interest rate is 3%.

11.	The demand for real money balances is a function of 
a.	Real income.
b.	The real interest rate.
c.	The nominal interest rate.
d.	(a) and (b)
e.	(a) and (c)
12.	Suppose the money demand equation is
(M/P)D = .25Y
Which of the following statements is true?
a.	The income velocity of money is equal to 4.
b.	The income velocity of money is constant.
c.	Money demand is independent of the interest rate.
d.	(a), (b), and (c) are all true.

13.	The classical dichotomy tells us
a.	That a change in the money supply changes the values of the real variables in the Classical Model.
b.	That the price level in the economy is determined in the money market.
c.	That a change in the price level must reflect a change in real GDP.
d.	That a change in the money supply is neutral in its effect on real GDP only in the short run.

14.	The Classical Mode is particularly insightful when considering 
a.	The current year.
b.	Economic recessions.
c.	Economic expansions.
d.	The long run.
e.	The short run.

Problems:

1.	Use the information in the table below to answer this question.
Year	Money Supply (M)	Velocity (V)	Price Level (P)	Real GDP (Y)	
1998	100	2	1		
1999	105	2.02		202	
2000	110		1.08	206.76	
2001		2	1.05	213.33	
a.	Fill in the missing values in the above table using the Quantity Equation (you might find it helpful and instructive to use an Excel Spreadsheet with formulas).
b.	Now fill in the table below using the data that was given to you and that you calculated.
Year	% Change in M	% Change in V	% Change in P	% Change in Y	
1998-1999					
1999-2000					
2000-2001					

c.	Is the sum of the % change in M and the % change in V a good approximation of the % change in nominal GDP?  Explain your answer and support it with your numerical calculations.
d.	Is the sum of the % change in M and the % change in V a good approximation of the % change in real GDP?  Explain your answer and support it with your numerical calculations.

2.	The question uses the Fisher Equation.
a.	Use the Fisher Equation to complete the following table.
Real Interest Rate (%)	Nominal Interest Rate (%)	Inflation Rate (%)	
	5	2	
	5	4	
	5	6	
4	6		
-2	8		
3		6	
-1		4	

b.	Recall that the percentage change in the price level is approximately equal to the percentage change in the money supply if velocity is assumed to be constant and long-run annual growth of real GDP is also assumed to be constant.  Use this information to complete the following table.

% change in P	% change in M	Inflation Rate (%)	Real Interest Rate (%)	Nominal Interest Rate (%)	
0	2	0	3	3	
	3		3		
	4		3		
	1		3		
	6		3		

c.	Compute the following table recalling the distinction between the ex ante real interest rate and the ex post real interest rate.
Nominal Interest Rate (%)	Expected Inflation (%)	Ex Ante Real Interest Rate (%)	Actual Inflation (%)	Ex Post Real Interest Rate (%)	
10		6		5	
8		4		5	
3	4		4		
5	2		1		
1	-1	2	0	1	

i.	As a lender is it better for you if the ex ante real interest rate is greater than the ex post real interest rate or if the ex ante real interest rate is less than the ex post real interest rate?  Explain your answer.
ii.	Answer (2i) from the borrower’s perspective.

3.	Suppose you are given the money demand function below:
(M/P)D = i-0.2Y
where (M/P) = real money balances
i = nominal interest rate
Y = real GDP
a.  Use this information to complete the following table. (Use an Excel spreadsheet with formulas!)
Nominal Interest Rate i	i -0.2 (four places past the decimal)	Real Output Y	Real Money Demand (0 places past the decimal)	
0.10 = 10%		1000		
0.11		1000		
0.06		1000		
0.03		1000		
b.	Study the data you collected in (a).  What is the relationship between the quantity of real money balances demanded and the nominal interest rate for a given level of real GDP?
c.	Suppose real GDP increases to 1200.  Recalculate the values for the table using your spreadsheet program.  Enter your findings in the table below.

Nominal Interest Rate i	i -0.2 (four places past the decimal)	Real Output Y	Real Money Demand (0 places past the decimal)	
0.10 = 10%		1200		
0.11		1200		
0.06		1200		
0.03		1200		

d.	Plot the real money demand and the nominal interest rate (with the nominal interest rate on the y-axis) that you found in (a) and (c).  Describe what happened to the real money demand function when real GDP increased.

4.	Suppose we start with the money demand function given in problem (3).  Furthermore, assume real output is initially at 1000 and the nominal interest rate is 3%.
a.	What is the quantity of real money balances demanded?
b.	Now suppose that the initial price level is equal to 1 and there is no expected inflation.  The money market will be in equilibrium when money demand equals money supply.  For this economy, what level of the nominal money supply will the Fed need to set?
c.	Now, suppose people believe the Fed will soon engage in expansionary monetary policy and that the nominal money supply will grow by 7% per year.  What does this to do inflationary expectations?
d.	Given the events in (c), what do you expect to happen to the nominal interest rate?
e.	If real output remains constant at 1000, what will happen to the quantity of real money balances demanded given (c) and (d)?
f.	Since the nominal money supply has not been changed, what does this imply about the price level?
g.	From this exercise, what can you conclude about the relationship between expected money growth in the future and the current price level?

5.	Suppose you lived in an economy that did not have money.  In this economy, four goods are produced.  
a.	In the absence of money, how many price ratios would there be?  
b.	Provide a generalized formula for the calculation of the number of price ratios in an economy with n goods.

6.	In class we saw that the formula for calculating the real interest rate could be approximated by
r = i – expected inflation rate
An exact formulation of the relationship between the real interest rate, nominal interest rate, and the inflation rate is 
(1 + r) = (1 + i)/(1 + expected inflation)
Suppose you start initially with $100 and you earn an interest rate of 100% per year.
a.	At the end of the first year, how much money would you have?
b.	Suppose inflation is also 100% per year and that the initial price level is 1.0.  At the end of the first year, what is the new price level?
c.	What was the real value of your wealth at the beginning of the first year?
d.	What was the real value of your wealth at the end of the first year?
e.	Use these real values to calculate the value of the real interest rate.
f.	Compare the results in (e) to what you would find using the approximation formula and the exact formula.