hw5 - University of Wisconsin Department of Economics...

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ECON103A Discuss Session Fri, Nov 9 Grace Waner Gu [email protected] CH4(5 th editon): i).QR6: Who pays the inflation tax? The holders of money pay the inflation tax. As prices rise, the real value of the money that people hold falls—that is, a given amount of money buys fewer goods and services since prices are higher. ii). QR7: If inflation rises from 6 to 8 percent, what happens to real and nominal interest rates according to the Fisher effect? The Fisher equation expresses the relationship between nominal and real interest rates. It says that the nominal interest rate i equals the real interest rate r plus the inflation rateπ: i = r + π.This tells us that the nominal interest rate can change either because the real interest rate changes or the inflation rate changes. The real interest rate is assumed to be unaffected by inflation.It adjusts to equilibrate saving and investment. There is thus a one-to-one relationship between the inflation rate and the nominal interest rate: if inflation increases by 1 percent, then the nominal interest rate also increases by 1 percent. This one-to-one relationship is called the Fisher effect. If inflation increases from 6 to 8 percent, then the Fisher effect implies that the nominal interest rate increases by 2 percentage points, while the real interest rate remains constant. iii). QR8: List all the costs of inflation you can think of, and rank them according to how important you think they are. The costs of expected inflation include the following: a. Shoeleather costs . Higher inflation means higher nominal interest rates, which mean that people want to hold lower real money balances. If people hold lower money balances, they must make more frequent trips to the bank to withdraw money. This is inconvenient (and it causes shoes to wear out more quickly). b.
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hw5 - University of Wisconsin Department of Economics...

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