Lecturer-led Tutorial for Chapter 5 (2023)

• You must know how to use the quantity equation in a variety of “settings”.
• You must be familiar with the money demand-money supply diagram with value of
money and price level on the axes.
• You must know Keynes’ motives for holding money. (This is a topic that is also needed
when studying the IS-LM model.)
• You must be familiar with concepts such as classical dichotomy, monetary neutrality,
seigniorage and the inflation tax.
• You must know what causes a hyperinflation and the suggestions of how to bring such
an episode to a close.
• You must know the different theories of inflation.
• You must know the Fisher effect and how to use it (in both the simple situation and when
taking it a step further to analyse one’s ex ante expectation vs the ex post reality)
• You must know the costs of inflation (both when inflation is expected and when it is
unexpected)

1. You have been presented with the following information about Ursa Minor:
Velocity of money is constant
Real GDP is growing at 6% per annum
Money stock is growing at 9% per annum
Nominal interest rate is 7%

a) Using the quantity theory of money and the Fisher equation, what should Ursa Minor’s
inflation rate and the real interest be?
b) Ceteris paribus, Ursa Minor’s Central Bank decides to lower inflation by lowering the
money supply growth rate to 8%. What would the equilibrium values of inflation and the
real interest rate be after this adjustment?

2. You have been appointed to advise the Zimbabwean government on whether to print its
own money or to use the money of its larger neighbour (i.e., South Africa). Using the
knowledge you acquired whilst studying Chapter 5, explain, in a few sentences, to the
Zimbabwean parliament what the likely costs and benefits of a national money would
be. (Hint: ensure that you have considered the role of seigniorage.) Furthermore,
ensure that you have touched on the role that political stability takes when making such
a recommendation.

A major benefit of having a national money is seigniorage – the ability of the government
to raise revenue by printing money. The major cost is the possibility of inflation, or even
hyperinflation, if the government relies too heavily on seigniorage and prints too much
money. The foreign country’s political stability is a key factor to consider. Zimbabwe
could gain the price stability of South Africa by using our currency. But, Zimbabwe
should not use the currency of a country less stable than itself, since then it would lose
the seigniorage and lose price stability.
3. The real side of MadibazLand’s economy is characterised as follows:

Y = 80K0.5L0.5 K = 100
L = 100 G = 3 000
T = 3 000 I = 2 000 – 6 000r
C = 600 + 0.6(Y – T)

The nominal side of MadibazLand’s economy is characterised as follows:

Real money demand: (M/P)d = 0.2Y – 1 000r

Nominal money supply: M = 3 000
where P is aggregate price level and M is nominal money stock

a) Calculate the following: real GDP, real interest rate (use as a decimal figure), real wage
rate, aggregate price level and nominal wage rate.
b) The MadibazLand’s Central Bank subsequently buys bonds from the public. This open
market operation raises the country’s nominal money supply by 10%. Calculate the new
values of real GDP, real interest rate, real wage rate, aggregate price level and nominal
wage rate. Does the Classical Dichotomy hold in MadibazLand? Justify your answer.

4. DassieLand is a country that produces a single type of good called a widget. Widgets
cost R2 a piece and 3 million widgets are currently being produced in DassieLand. The
country of DassieLand is suffering an economic downturn. One economist suggests a
solution to the President of DassieLand: drop additional currency into the country using
a helicopter. Prior to the dropping of currency by the helicopter there are R900 000 in
circulation in DassieLand.
Use the Classical Quantity Theory of Money to answer the following questions.
a) Assume DassieLand is in monetary equilibrium (i.e., money demand equals money
supply) prior to the helicopter drop. What is the ratio of desired money holdings to
income?
b) If the helicopter drops R45 000 on the country, what will the new price of a widget be?
c) What is the impact of the helicopter drop on DassieLand's level of real output? Explain
your answer.
d) Another economist disagrees with the helicopter idea. She recommends that the
President should increase government spending on national defence and pay for the
increase by enlarging the nation's deficit. She claims this will increase the real GDP of
the country and therefore the average standard of living will be higher next year.
According to the Classical Model will this policy result in any change in real output? If
there's a change, what kind of change in real output will there be? Give a reason for
your answer.

5. Economists working for KnoxVille’s statistical department noted that velocity is constant at
5, real output is 20 and the price level is 2. From this initial situation, the nominal money
supply is increased to 10. If velocity and output remain unchanged the price level increases
by ___%.

6. Fishermania is a country in which the quantity theory of money operates. In 2020, the
money supply was R2 000 000. The nominal GDP was R24 000 000 and real GDP was
R8 000 000.
a) Use the aforementioned data to calculate the price level in Fishermania.
b) Use the aforementioned data to calculate the velocity of money.
c) Suppose that the velocity is constant and that technological progress caused the
economy’s output of goods and services to rise by 4% over the course of the past year.
What money supply should the central bank of Fishermania set in 2021 if it wants an
inflation rate of 5%? [Ensure that your answer includes both the new “rand” figure for
money supply and the percentage change in money supply.]

Example:
A labour contract provides for a first-year wage of R12.00 per hour and specifies that
the real wage will rise by 2% percent in the second year of the contract and by another
2% in the third year. The CPI is 100 in the first year, 105 in the second year, and 110 in
the third year. What are the rand wages that must be paid in the second and third years
of the contract? (Round off to the second decimal place.)
Because the CPI is 100 in the first year, both the nominal wage and the real wage are
R12.00.
Let W2 stand for the nominal wage in the second year.
Deflating by the CPI in the second year, we can express the real wage in the second
year as W2/(105 – 100)/100 * 100. (Remember: w = W/P)
The contract says that the second-year real wage must be 2% higher than the real wage
𝑊𝑊 12∗1.02 𝑊𝑊2 12.24
in the first year, so 2 = = 1.05 = .
1.05 1 1
Multiplying through by 1.05 to solve for W2.
We get W2 = R12.85, the nominal wage required by the contract in the second year.
In the third year the nominal wage W3 must satisfy the equation W3/(110 – 105)/105*100
= R12.24 * 1.02 = R12.48. Solving this equation for W3 yields R13.73 as the nominal
wage that must be paid in the third year.

7. A labour contract provides for a first-year wage of R20 per hour, and specifies that the
real wage will rise by 2.5% in the second year of the contract and by another 2% in the
third year. The CPI is 100 in the first year, 106 in the second year and 113 in the third
year. What rand wage must be paid in the third year? (Round off to the second decimal
place.)

Because the CPI is 100 in the first year, both the nominal and real wage are R20.00.
Inflation from Year 1 to Year 2 = (106 -100)/100 * 100 = 6%
Year 2: Nominal wage adjustment: 20 + 6% = 21.20.
Year 2: Real wage adjustment: 21.20 + 2.5% = 21.73
Inflation from Year 2 to Year 3 = (113 – 106) / 106 * 100 = 6.6%
Year 3: Nominal wage adjustment: 21.73 + 6.6% = 23.16418.
Year 3: Real wage adjustment: 23.16418 + 2% = 23.6274636 = 23.63

8. Suppose that in FischerVille velocity is 2.5, real output is 8 500 and the price level is 6.
What is the level of real money demand in this economy?

9. In AcaciaLand, currency in circulation (C) is R1.2 million and the monetary base (B) is
R3.7 million. Assume the reserve-deposit ratio and the currency-deposit ratio are both
0.25.
a) What is the size of bank reserves (R)?
b) What is the money multiplier?
c) What is the money supply?
d) What is the velocity of money if nominal GDP is R17 million? (Round off to the second
decimal place)
10. Suppose real money demand in an economy is characterised by
M D

= e * Y - f * i , where e = 0.6 and f = 500. Assume that the nominal money

P
supply, denoted M0, equals 630.
a) Calculate the price level, P, assuming that output, Y, equals 1000 and the interest rate
is 5%. (Round off to the third decimal place.)
b) Assume that the nominal wage in the economy, W, equals, 20, and that it is fixed at this
level for the next year. Calculate the resulting real wage. (Round off to the second
decimal place.)

11. Money demand in an economy in which no interest is paid on money is:

(M/P)d = 800 + 0.5Y – 1 000i
Suppose that P = 120, Y = 1 000, and i = 0.1. Find real money demand, nominal money
demand and the velocity of money.

12. In the economy of Yellenland, the commercial banks have deposits of R4 million. Their
reserves are R1 million. All reserves are in deposits with the Central Bank and the
commercial banks hold no excess reserves. There is R2 million in Central Bank notes
outside the banks, and there are no coins.
a) What is the economy’s monetary base? [Ensure that you have shown all your workings
as well as the formulae you used. Relevant theory may also be mentioned.]
b) What is the quantity of money in the economy? [Ensure that you have shown all your
workings as well as the formulae you used. Relevant theory may also be mentioned.]
c) Calculate the money multiplier. [Ensure that you have shown all your workings as well
as the formulae you used.]
d) Suppose the Central Bank of Yellenland decides to sell R25.5 million worth of
government bonds to the public.
d.1 By how much will the quantity of money change? [Ensure that you have shown all your
workings as well as the formulae you used. Furthermore, indicate whether the quantity
of money will increase or decrease.]
d.2 Use a fully-labelled graph to illustrate and explain what happens to the money supply,
money demand, the value of money, and the price level due to the open market sale of
government bonds.
13. Refer to the diagram below.

AloeLand’s real GDP in 2020 was R18 000. The relevant money-demand curve was the
one labelled MD1. If the money market was in equilibrium, then how many times per year
was the typical Rand used to pay for a newly produced good or service?

14. The money market of MadibaVille has the following money supply and demand
equations:
Money Supply: M/P = 8000
Money Demand: (M/P)d = 10 000 – 40 000r
Where money is in rands and interest rates, r, is written as a decimal (e.g., an interest
rate of 20% would be written as 0.2 in the equation).
a) Draw the money supply and demand curves, putting the quantity of money on the
horizontal axis and the interest rate (in percent) on the vertical axis. Indicate the slope
and intercept of each curve.
b) Calculate the equilibrium interest rate and amount of money.
c) Give a brief explanation as to why the interest and prices of bonds are negatively related.
d) Suppose the interest rate in the money market in MadibaVille is currently at 10%. What
is the amount of excess supply of or excess demand for money? How will the market
adjust back to the equilibrium?
e) Suppose that the government of MadibaVille likes the interest rate at 10%. What is the
amount of increase or decrease in its money supply that will allow it to reach such an
interest rate in equilibrium?
f) Which motive for holding money shifts the money demand curve?
g) Which motive for holding money causes movements along the same money demand
curve?

15. Nadine is lending Liyema R1 000 for one year. The CPI is 180 at the time the loan is
made. They expect it to be 189 in one year. If Nadine and Liyema agree that Nadine
should earn a 3% real return for the year, calculate the nominal interest rate on this loan.

16. In 2021 Yonela lent R15 000 to Sanele. Sanele repaid the loan, together with an
additional R2 400 for the use of Yonela’s money, exactly one year later. Both Sanele
and Yonela expected inflation to increase by 8 percentage points between 2021 and
2022. However, data released by the country’s National Statistical Service indicate that
over that period the price level increased from 150 to 168.
a) Who benefits from the higher-than-expected inflation rate?
b) What is the ex pos real interest rate for the loan equal to?
Example:
Asemahle lives in AlgoaVille. In 2020 the price index was 135 and Asemahle purchased
R40 000 worth of bonds. One year later (i.e., in 2021) the price index was 141.75.
Asemahle redeemed her bonds for R43 200. It was noted that Asemahle was in the
10% tax bracket. What was Asemahle’s real after-tax rate of interest?

Real interest rate (nominal interest rate – inflation rate) 3%

(8% - 5%)
Inflation rate 5%
(141.75 – 135)/135 * 100
Nominal interest rate/gain 8%
(43 200 – 40 000)/40 000 * 100
Nominal interest rate = real interest rate + inflation rate
Reduced interest due to 10% tax 0.8%
(0.1 * nominal interest rate)
(0.1 * 8)
After-tax nominal interest rate 7.2%
(0.9 * nominal interest rate)
Or
(Nominal interest rate – reduced interest due to 10% tax)
After-tax real interest rate 2.2%
(After-tax nominal interest rate – inflation rate)

17. You put money into an account and earn a real interest rate of 4%. Inflation in Economy
A is 0% and in Economy B it is 8%. The marginal tax rate in both countries is 25%. In
which country is your after-tax real interest rate higher? (Suggestion – use a table)

18. In 2018 you deposited money into an account that would pay out a nominal interest rate
of 9%. The price index in 2018 was 150. One year later you earn an after-tax real
interest rate of 1.2%. The price index in 2019 was 159. Into which tax bracket do you
fall?
a) 15%
b) 20%.
c) 35%.
d) 40%.
e) 50%.

19. Siya owns a hardware shop. Siya has determined that he needs R5 000 cash per day
for customer transactions. Siya has a choice between going to the bank first thing on
Monday morning to withdraw R25 000 - enough cash for the whole week - or going to
the bank first thing every morning to withdraw R5 000. (I.e., Siya would withdraw R5 000
each morning.) Siya puts the cost of going to the bank at R4 per trip. Assume that funds
left in the bank earn precisely enough interest to keep their purchasing power unaffected
by inflation. Siya’s hardware shop is open five days a week for 50 weeks each year.
a) Calculate Siya's annual shoe leather costs of inflation.
b) If Siya goes to the bank every day when the inflation rate is 10%, then would the daily
trips to the bank result in a net loss or a net saving?
c) How large would this loss or saving be?

Siya has two options.

First, he can go to the bank once per week; in this case his average cash holding at the
beginning of the day is R15 000 [(25 000 + 20 000 + 15 000 + 10 000 + 5 000)/5], and
the cost of his trips to the bank is R200 [R4 per trip times 50 trips per year].
 Second, he can go to the bank every day, reducing his average cash holding to R5 000
but increasing his cost of trips to the bank to R1 000 [R4 per trip times 250 trips].
Siya’s benefit from going to the bank each day (relative to his previous practice of weekly
trips) is that his average cash holdings are reduced by R10 000, so that he loses less
purchasing power to inflation. If inflation is 10%, the real benefit of reducing cash
holdings by R10 000 is 10% times R10 000, or R1 000. The cost of going to the bank
every day (shoe-leather cost – based on the extra trips undertaken) is R800 [1 000 –
200] more than the cost of going once a week. Since the extra cost of going to the bank
more often (R800) is less than the extra benefit (R1 000), Siya will go to the bank daily.

a) Shoe-leather cost: R800

b) Net saving
c) Net saving of R200

20. The Right Way to Beat Chinese Inflation

“High inflation is threatening social stability in China, soaring from 3.3% in March 2007
to 8.3% in March 2008.
…
China’s accelerating inflation reflects a similar climb in its GDP growth rate, from the
already high 11% in 2006 to 11.5% in 2007. The proximate cause of price growth since
mid-2007 is the appearance of production bottlenecks as domestic demand exceeds
supply in an increasing number of sectors, such as power generation, transportation,
and intermediate-goods industries.
…
The prolonged rapid increase in Chinese aggregate demand has been fueled by an
investment boom, as well as a growing trade surplus.”
Source: https://www.brookings.edu/opinions/the-right-way-to-beat-chinese-inflation/

a) Is China experiencing demand-pull or cost-push inflation? Explain.

b) Draw a graph to illustrate the initial rise in the price level and the money wage rate
response to a one-time rise in the price level.
c) Draw a graph to illustrate and explain how China might experience an inflation spiral.

a) China is experiencing a demand-pull inflation because both the price level and real GDP
are increasing.

b) The figure below shows the effect of a one-time increase in the price level that results
from a one-time increase in aggregate demand.

The aggregate demand curve shifts rightward from AD0 to AD1 and the price level rises
from 130 to 132. Real GDP also increases and, in response to the tight labour market,
the money wage rate rises. Aggregate supply decreases so that the SAS curve shifts
leftward from SAS0 to SAS1. The price level rises still more from 132 to 134. Once at
 134, the price level stops rising so there is not an on-going inflation.

c) The figure below shows how the situation in Question 20(b) can change into a demand-
pull inflation spiral.

After the short-run aggregate supply decreases to SAS1 and the economy is back at full
employment, an increase in the quantity of money by the central bank increases
aggregate demand and the aggregate demand curve, shifts rightward to AD2. The price
level rises to 136 and, just as in Question 20(b), the money wage rate rises again so
that the short-run aggregate supply once more decreases. After the decrease in short-
run aggregate supply to SAS2 the price level rises still higher to 138. As long as the
quantity of money continues to increase, the inflation spiral will continue with aggregate
demand increasing and short-run aggregate supply decreasing.

21. A dull Reserve Bank meeting may be a good thing

As markets get jittery about inflation and interest rates, the Bank is a sea of calm
calculation…Governor Lesetja Kganyago will see having been able to keep interest
rates at 50-year lows as a vindication of past policy. Two months ago, some of SA’s
peers in emerging markets, namely Turkey, Russia and Brazil, already tightened policy.
“If you want lower interest rates you have got to have lower inflation,” Kganyago told
Business Day a month ago, comments that made it clear the Bank is in no rush to raise
interest rates, even though its projection model suggested that policy tightening would
start in the second quarter.
Source: https://www.businesslive.co.za/bd/opinion/editorials/2021-05-19-editorial-a-
dull-reserve-bank-meeting-may-be-a-good-thing/

The view being expressed by Governor Lesetja Kganyago above are that of…
a) The monetarist approach to inflation
b) Cost-push inflation
c) Demand-pull inflation
d) The conflict approach

22. Briefly explain the conflict approach to inflation.

Mohr et al 2015 states that inflation I a symptom of a fundamental disharmony in society
which results in a continuous imbalance between the rate of growth of the total effective
claims on this income. The different economic and social groups together claim more
income than is produced. As the rival groups (trade unions, employer organisations,
large firms, business organisations, professional associations etc.) each try to claim
more than their share

23. In a particular country the money demand function takes the form (M/P)d = 0.5Y/(i0.5),
where M is the quantity of money, P is the price level, Y is real output and i is the nominal
interest rate. Calculate the velocity if the nominal interest rate is 12.25%
 To find an expression for the velocity of money, start with the quantity equation MV =
PY and rewrite this as M/P = Y/V. In equilibrium, the real money supply M/P is equal to
real money demand, so
𝑌𝑌 0.5𝑌𝑌
= 0.5
𝑉𝑉 𝑖𝑖
𝑖𝑖 0.5 𝑌𝑌 = 0.5𝑌𝑌𝑌𝑌
𝑖𝑖 0.5 𝑌𝑌
= 0.5𝑉𝑉
𝑌𝑌
0.5
𝑖𝑖
= 0.5𝑉𝑉
1
𝑖𝑖 0.5 = 0.5𝑉𝑉
2𝑖𝑖 0.5 = 𝑉𝑉
2(12.25)0.5 = 𝑉𝑉
7 = 𝑉𝑉

24. Real money demand is given by: Md/P = 800 + 0.6Y - 1000i. You are told that P = 15,
Y = 5K0.5L0.5, K = 100 and i = 0.05. Furthermore, suppose you know that the labour
market in this economy can be described by the following demand and supply curves
where “w” is the wage rate: Demand for labour: L = 300 – 5w; Supply of labour: L = 15w.
Calculate:
a) real money demand.
b) velocity.
c) the money demand parameter.