2) One concern about economies with high sovereign default...

2) One concern about economies with high sovereign default is the possibility that governments will be tempted to change inflation in order to keep the debt/GDP ratio from exploding. Let's examine this concern in a model with inflation. Suppose that GDP is equal to $PY$ where $P_t$ is the price level at time $t$, which grows at inflation rate, $\pi_t = (P_t - P_{t-1})/P_{t-1}$: and $Y$ is the level of real income in the economy which is assumed to be constant. The government is assumed to issue nominal debt, $D_t$, and its intertemporal budget constraint is given by (1). The debt-to-GDP ratio is given by $d_t = D_t/(P_tY)$ and the primary balance relative to GDP is $pb_t = (T_t - G_t)/(P_tY)$. Derive the value of $pb_t$ that is required to keep debt-to-GDP at a constant value, $d > 0$. Will $pb_t$ be negative or positive if inflation exceeds $i$ ($i < \pi$)?

Transcript

00:02 A reduction in the inflation rate would make relative prices, a, less variable, making it more likely that resources will be allocated to their best use.

00:11 B, more variable, making it more likely that resources will be allocated to their best use.

00:17 C, more variable, making it less likely that resources will be allocated to their best use.

00:22 Or, d, less variable, making it less likely that resources will be allocated to their best use.

00:28 So economists tend to watch inflation very closely.

00:43 So remember, inflation is the rise in prices, and it would mean, so what cost a dollar today might now cost a dollar five, which means i can buy less with my dollar.

00:56 So it affects our purchasing power.

00:58 So they tend to watch inflation very closely, since it can sometimes be a leading indicator of real output.

01:31 Inflation can also be a problem when it is too high, which is why the central bank is given the goal of keeping inflation low and stable.

02:32 Some inflation is normal.

02:34 We usually see an average of 2 to 3 % inflation from any given year to the next year.

02:39 That's considered normal.

02:41 When it gets to be more than that, that's when there starts to be cost for concern.

02:46 If we start seeing 5, 6, 7, 8 % and above, we're going to start having cost for concern.

02:52 And when it's more than that, when inflation is rising too fast, that's referred to as hyperinflation.

02:58 So we do want somebody looking at this, in this case the central bank, to ensure that it's not rising too high and then it's not rising too high too fast.

03:07 So the correct answer here is a less variable, making it more likely that resources will be allocated to their best use.

03:16 The less variable relative prices are, the easier it is to plan, how to best allocate resources to their best use.

04:05 This is because uncertainty increases the chance of miscalculation and a reduction in inflation reduces the variability of relative prices since prices move slower overall and therefore planning is easier.

04:28 Suppose the money supply grew at an average annual rate of 8%.

04:33 Velocity was constant.

04:34 The nominal interest rate averaged 9%, and output grew at an average annual rate of 3%.

04:40 According to the quantity theory, which of the following is true.

04:45 A, inflation averaged 8 % per year and the real rate of return was 9%.

04:50 B, inflation averaged 1 % per year and the real rate of return was 6%.

04:55 C, inflation averaged 5 % per year, and the real rate of return was 6%.

04:58 And the real rate of return was 4%.

05:01 Or d, inflation averaged 11 % per year, and the real rate of inflation was 17%.

05:08 So the quantity theory of money states that the money in circulation is directly related to the nominal price level in the economy.

06:07 The equation qtm consists of four variables.

06:22 Money supply, velocity of the money supply, price level and the level of output of the economy.

06:46 The correct option here is c.

06:49 Inflation averaged 5 % per year, and the real rate of return was 4%.

06:55 So to figure this out, remember we are given that the percentage change in money is 8.

07:02 The percentage change of velocity is zero because it was constant.

07:13 The interest is 9%.

07:15 And the percentage change in the average annual rate, the yield is 3%.

07:29 So according to the quantity theory of money, the inflation level is the percentage change of the money supply plus the percentage change of velocity equals the percentage change in price plus the percentage change in the yield or the annual rate.

07:54 This gives us 8 % plus 0 % equals the rate.

07:59 The percentage change in p plus 3%...

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