# Economics

## Quiz 21 :Production and Growth

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INFLATION AND INTEREST RATES Using a demand-supply diagram for loanable funds (like Exhibit 10), show what happens to the nominal interest rate and the equilibrium quantity of loans when both borrowers and lenders increase their estimates of the expected inflation rate from 5 percent to 10 percent.
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Impact of expected inflation upon nominal interest rate and loanable funds:
Expected inflation and expected real interest rate are inversely related, given the nominal interest rate. In simple words, real interest rate would fall in future when expected inflation is high with given level of nominal interest rate.Expected fall in future real interest rate due to higher expected inflation will cause supplier to lend less and demanders to demand more, at each level of nominal interest rate, and thereby, demand will increase and supply will fall. Thus, nominal interest rate will increase. However, change in quantity of loanable funds depends on the expectation formulation of both suppliers and demanders.
For example, if expectation formulation toward inflation is same for both the suppliers and demanders, then the quantity of loanable funds will not change, which is shown in the below figure.Impact of expected inflation:
Figure-1
In Figure-1, initial equilibrium was at point "A" with 5 percent nominal interest rate and inflation, respectively, which means that the real interest rate was zero. Now, the expected inflation increases by 5 percent, that is, it increases from 5 to 10 percent and is same for both suppliers and demanders. Now, same expectation formulation will lead to an increase in demand for loan (rightward shift) and fall in supply of loanable funds (leftward shift). The new equilibrium will be at point "B". Hence, nominal interest will increase exactly by 5 percent and quantity of loanable fund remains unchanged.

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ANTICIPATED VERSUS UNANTICIPATED INFLATION If actual inflation exceeds anticipated inflation, who will lose purchasing power and who will gain?
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Actual inflation and anticipated inflation
Actual inflation is the sum of anticipated inflation and unanticipated inflation. Anticipated inflation is expected while unanticipated inflation is unexpected or random in nature.When actual inflation is equal to the anticipated inflation, the unanticipated inflation is zero; when actual inflation is less than the anticipated inflation, the unanticipated inflation is negative. Similarly, when actual inflation is greater than the anticipated inflation, the unanticipated inflation is positive.If actual inflation is greater than the anticipated inflation, then the sellers of goods and services who had agreement to sale at price prior to inflation will lose their purchasing power and the buyers who agreed to purchase at that price will gain purchasing power.
Similarly, the lenders those who agreed to lend at nominal interest rate prior to inflation will lose their purchasing power and borrowers those who borrowed at that nominal interest rate will gain purchasing power.

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Inflation Here are some recent data on the U.S. consumer price index: Compute the inflation rate for each year 1993-2009 and determine which years were years of inflation. In which years did deflation occur? In which years did disinflation occur? Was there hyperinflation in any year?
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Inflation can be defined as an instance, over the course of a year, during which the price level increases. Deflation is just the opposite; the price level decreases. Disinflation refers to a state of decreasing inflation levels. Hyperinflation, though with no specific threshold, is a particularly high level of inflation.
To calculate the inflation rate using the CPI, simply subtract the previous year's CPI from the current year to calculate the rate of inflation. An example is shown below, where I is equal to inflation.
Over the next 15 years, in order, the inflation (or deflation) rates were as follows:
3.7, 4.2, 4.5, 3.6, 2.5, 3.6, 5.6, 4.9, 2.8, 4.1, 4.9, 6.4, 6.3, 8.0, and -0.8.
The only time deflation occurred was from 2008 to 2009; the inflation rate was -0.8. Disinflation occurred between 1996-1998, 2000-2002, and 2005-2006. Since hyperinflation is hard to define, it should be taken as extremely high instances of inflation relative to other levels. Thus, in these calculations for example, it should be considered hyperinflation when the rate reaches 6% or more. This occurred in years 2004-2008.

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INTERNATIONAL COMPARISONS OF UNEMPLOYMENT How has the U.S. unemployment rate compared with rates in other major economies? Can you offer any reasons why rates on average have differed across major economies during the last three decades?
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INFLATION Why do people dislike inflation?
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LABOR FORCE Refer to Exhibit 1 in the chapter to determine whether each of the following statements is true or false. a. Some people who are officially unemployed are not in the labor force. b. Some people in the labor force are not working. c. Everyone who is not unemployed is in the labor force. d. Some people who are not working are not unemployed.
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INFLATION AND INTEREST RATES Explain as carefully as you can why borrowers would be willing to pay a higher interest rate if they expected the inflation rate to increase in the future.
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TYPES OF UNEMPLOYMENT Determine whether each of the following would be considered frictional, structural, seasonal, or cyclical unemployment: a. A UPS employee who was hired for the Christmas season is laid off after Christmas. b. A worker is laid off due to reduced aggregate demand in the economy. c. A worker in a DVD rental store becomes unemployed as video-on-demand service becomes more popular. d. A new college graduate is looking for employment.
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INFLATION AND RELATIVE PRICE CHANGES What does the consumer price index measure? Does the index measure changes in relative prices? Why, or why not?
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SOURCES OF INFLATION Using the concepts of aggregate supply and aggregate demand, explain why inflation usually increases during wartime.
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UNEMPLOYMENT IN VARIOUS GROUPS Does the overall unemployment rate offer an accurate picture of the impact of unemployment on each U.S. population group?
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INFLATION Why is a relatively constant and predictable inflation rate less harmful to an economy than a rate that fluctuates unpredictably?
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MEASURING UNEMPLOYMENT Determine the impact on each of the following if 2 million formerly unemployed workers decide to return to school full time and stop looking for work: a. The labor force participation rate b. The size of the labor force c. The unemployment rate
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Login to www.cengagebrain.com and access the Global Economic Watch to do this exercise. Global Economic Watch and Case Study: Hyperinflation in Zimbabwe Go to the Global Economic Crisis Resource Center. Select Global Issues in Context. In the Basic Search box at the top of the page, enter the word "hyperinflation." On the Results page, go to the Magazines Section. Click on the link for the February 2, 2009, article "What Currency Crisis?" At the time of publication of the article, what was the price in Zimbabwean dollars of a loaf of bread? Reference Case Study: Bringing Theory to Life Hyperinflation in Zimbabwe In the troubled nation of Zimbabwe in southern Africa, the Zimbabwean dollar was once worth about 1.59 U.S. dollars. But the collapse of the economy in the early 2000s severely devalued the Zimbabwean dollar. The government tried paying its bills by printing huge amounts of money, and the result was inflation on an epic scale-hyperinflation. Consider this: The price level at the end of 2008 was 150 million times higher than at the beginning of that year. To put that in perspective, with such inflation in the United States, a gallon of gasoline that sold for $2.75 at the beginning of the year would cost$412.5 million by year-end. Jeans that sold for $25 would cost$3.8 billion at year-end. With the value of the Zimbabwean dollar cheapening by the hour, nobody wanted to hold any for long. Those fortunate enough to have jobs in this wreck of an economy wanted to get paid at least daily; they then immediately spent their pay before prices climbed more. With such wild inflation, everyone, including merchants, had trouble keeping up with prices. Different price increases among sellers of the same product encouraged buyers to shop around more. Even though the government was printing money at an astounding rate, the huge spike in prices meant that it took mountains of cash to buy anything, an amount both difficult to round up and onerous to carry. For months, the maximum amount people could withdraw daily from their bank had the purchasing power of one U.S. dollar. Because carrying enough money for even small purchases became physically impossible, currency in Zimbabwe was issued in ever higher denominations, with the highest being a $100 trillion dollar note; that's$100,000,000,000,000. In addition to issuing these higher denominations, three times the central bank issued an entirely new series of notes, each a huge multiple of the previous one, while doing away with the old series. For example, the new Zimbabwean dollar issued in February 2009 exchanged for 1,000,000,000,000 of the dollars it replaced. Larger denominations and new series of notes facilitated transactions but fed inflation, which raged all the more. Many merchants would accept only stable currencies such as the U.S. dollar or the South African rand, and would rather barter than accept Zimbabwean currency. No question, the country had all kinds of other problems, but hyperinflation made everything worse. For example, Zimbabwe's GDP plunged 75 percent between 2006 and 2009, and the unemployment rate reached 90 percent. As a way out of the mess, by mid-2009 the government allowed all transactions to be conducted in foreign currencies, something that was already happening. The local currency, already worthless (a \$100 trillion note was worth only U.S. pennies), mostly disappeared. Thus, Zimbabwe is now under what it calls a "multiple currency system" and the country plans to operate that way until at least through 2012. Price inflation grew only five percent in 2009 under the multiple currency system. Although Zimbabwe ended its inflation nightmare, hyperinflation is usually flaring up somewhere in the world, as yet another country looks to print money as a "free lunch" solution to budget problems. For example, inflation in Venezuela reached 30 percent in 2010.

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OFFICIAL UNEMPLOYMENT FIGURES Explain why most experts believe that official U.S. data underestimate the actual rate of unemployment. What factors could make the official rate overstate the actual unemployment rate?
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Case Study: Hyperinflation in Zimbabwe In countries such as Zimbabwe, which had problems with high inflation, the increased use of another country's currency (such as the U.S. dollar) became common. Why do you suppose this occurred?
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SOURCES OF INFLATION What are the two sources of inflation? Illustrate them graphically.
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