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Q.1 A newspaper article once reported that the U.S. economy was experiencing a low rate of inflation. It said that "low inflation has a downside: 45 million recipients of Social Security and other benefits will see their checks go up by just 2.8 percent next year."
a. Why does inflation affect the increase in Social Security and other benefits?
b. Is this effect a cost of inflation, as the article suggests? Why or why not?
Q.2 Suppose a country has a money demand function (M/P)d = kY, where k is a constant parameter. The money supply grows by 12% per year, and real income grows by 4 percent per year.
a. What is the average inflation rate?
b. How would inflation be different if real income growth were higher? Explain.
c. Suppose, instead of a constant money demand function, the velocity of money in this economy was growing steadily because of financial innovation. How would that affect the inflation rate? Explain
The firms and workers in Alpha form expectations adaptively. The firms and workers in Omega form expectations rationally. Their otherwise identical economies are initially in equilibrium at the natural level of output with 10 percent inflation.
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