Show why a permanent rise in the growth of the money supply induces a jump in the price level at the date at which the rise is announced.

Q4. The inflation tax works only when inflation is unexpected. Explain. Do commercial banks benefit or lose from the inflation tax?

Answer:

There are three main ways in which a government can raise its revenue. On of these is by printing money. This method reacts as imposing an inflation tax. When government prints money as its need to finance its spending, the increase money supply gives birth to inflation. Inflation performs as the value of money in the hand of public falls, therefore as imposing a tax on holding money.

Usually, commercial banks set contracts with customer with an agreement of interest rate which is based on the rate of inflation expected at the time of agreement. The rate is fixed in the contract duration even though the inflation rate changes all the time. In the case of a long term loan, when the actual inflation rate is higher than the expected rate, the debtors gains since the amount they repay is less valuable. On the other hand, the commercial banks lose. In contrast, if the actual inflation rate turns out to be lower than the expected rate, the commercial banks gain as the repayment they receive worth more. The more variable the rate of inflation, the greater the risk that both debtors and commercial banks face. In case of risk, the indexation of interest rate is introduced to the public. It takes the form of writing contracts using a more stable foreign currency. Whether it is dependable needs to be tested.

Q5. Discuss money neutrality by considering the inflation rates of two countries, namely UK and Turkey given in the figure (Hint: think about how inflation affects relative prices each economy).

Answer:

As shown in the figure of Annual Inflation Rates, Turkey experienced a fluctuant inflation rate during the last four years between 20%and 75%. UK experienced a comparatively smooth inflation rate around 1.5%.

Money neutrality suggests that real money stock is the ratio of money supply to consumer price index (CPI). When money supply increases, the price will finally increase by the same proportion, therefore leave the real money stock unchanged. That is, change in money supply affects not the real variables but the nominal price. Here are two examples focus on different variables. In the case of real interest rate, we need to quote Fisher equation presents as i = r + ?. According to Fisher principle, a one percent growth in inflation rate will increase the nominal interest rate by one percent. Therefore, real interest rate stays constant. This suggests that in Turkey the fluctuation in inflation is followed by the fluctuation in nominal interest rate, and real interest rate tends to be steady. Same situation occurs in UK.

In the case of relative price, as it is shown in the figures below. The economy is in its equilibrium at point A initially with output 5000 and interest rate 5%, price level is 100 (Figure 2). When money supply increases by 10% which means the inflation rate is 10%, with the shift of LM curve to LM', LM' intersects IS curve at B. Point B represents a fall in real interest rate followed by an exceed demand in output. Because of exceed demand, firms begin to raise price, causing a shrink in real money supply until price increases by 10% the same as inflation rate. This is shown as the backward movement of LM' to LM. Then a new equilibrium appears with the original real interest rate and output level but a higher price of 110. As long as the price adjustment finishes rapidly, the money neutrality holds.

But if price adjustment slows down, the economy may spend a long time in disequilibrium. When the price change could not catch up with the change in inflation rate, money neutrality tends to be more difficult to hold in the short run in Turkey than in UK.