Question 5 Chapter 17 Using money creation to pay for government spending
Consider Tralfamadore, a hypothetical country that produces only burritos. In
... [Show More] 2013, a burrito is priced at
$2.00.
Complete the first row of the table with the quantity of burritos that can be bought with $700.
Note: In this problem, assume it is not possible to buy a fraction of a burrito, and always round down to the
nearest whole burrito.
Year
2013
2014
Price of a Burrito Burritos Bought with $700
(Dollars) (Quantity)
Points: 0.33 / 1
Suppose the government of Tralfamadore cannot raise sufficient tax revenues to pay its debts. In order to
meet its debt obligations, the government prints money. As a result, the money supply rises by 40% by
2014.
Assuming money neutrality holds, complete the second row of the table with the new price of a burrito and
the new quantity of burritosthat can be bought with $700 in 2014.
Explanation: Close Explanation
With $700, 350 burritos can be purchased at the initial price of $2.00 per burrito. Monetary neutrality
is the theory that a change in the money supply does not affect real variables like the number of
burritos produced. If monetary neutrality holds, a 40% increase in the money supply will be fully
reflected in the dollar price of a burrito. The price of a burrito will rise by 40% as well, from $2.00 to
$2.80. This causes a decrease in the purchasing power of money, so now $700 can buy
only .
It is important to note here that the increase in the money supply impacts only the purchasing power
of the cash (including money in non-inflation adjusted accounts and assets) held while the
government was printing money. Since wages tend to rise with the overall price level, nominal wages
will rise to reflect changes in the quantity of money, and the purchasing power of earnings will not be
350 250
291
2.00 2.80
2.00
inflation tax
The impact of the government's decision to raise revenue by printing money on the value money is known
as the .
Points: 1 / 1
Explanation: Close Explanation
When the government pays its debts by printing money, the value of the money will decline, a
phenomenon known as inflation tax. Specifically, $700 will purchase fewer burritos—approximately
250 compared with 350 before the government's decision to print money. By printing money in order
to pay its debts, the government effectively taxes anyone who holds money. The revenue raised by
this tax is known as seigniorage. [Show Less]