Chapter 2 -- Quiz -- Inflation

Thomas Piketty, Capital in the 21st Century (Harvard University Press 2014)

Patrick Toche

Question 1

In the United States, the United Kingdom, Germany, France, the following periods were characterized by:

  1. 1700-1900: low inflation — 1914-1929: high inflation — 2007-2014: low inflation.
  2. 1700-1900: low inflation — 1914-1929: low inflation — 2007-2014: high inflation.
  3. 1700-1900: low inflation — 1914-1929: high inflation — 2007-2014: high inflation.
  4. 1700-1900: high inflation — 1914-1929: high inflation — 2007-2014: low inflation.
  5. 1700-1900: high inflation — 1914-1929: low inflation — 2007-2014: high inflation.
  6. 1700-1900: high inflation — 1914-1929: low inflation — 2007-2014: low inflation.

'Low inflation' refers to annual inflation rates ranging from -1% to +2%. High inflation refers to annual inflation rates in excess of 4%. 'A period' refers to most years within the given dates (at least half of the time) and for most countries (at least 3 of 5 countries).

The period 1700-1914 was a period in which most currencies were pegged to gold or other precious metals at a fixed rate, resulting in moderate price fluctuations (caused mostly by gold discoveries and shortages). The period 1914-1929 was a period of post-war reconstruction, with government finances damaged by the first world war (especially Germany who was being forced to pay for the cost of the war), and goods and stock prices soaring. France and Germany experienced hyperinflation in the early 1920s. The period 2007-2014 was the period of the 'Great Recession', with countries (especially Europe and Japan) threatened by deflation.

Question 2

In the United States, the United Kingdom, Germany, France, the following periods were characterized by:

  1. 1914-1929: high inflation — 1970-1980: high inflation — 2007-2014: low inflation.
  2. 1914-1929: high inflation — 1970-1980: low inflation — 2007-2014: high inflation.
  3. 1914-1929: high inflation — 1970-1980: high inflation — 2007-2014: high inflation.
  4. 1914-1929: low inflation — 1970-1980: high inflation — 2007-2014: low inflation.
  5. 1914-1929: low inflation — 1970-1980: low inflation — 2007-2014: high inflation.
  6. 1914-1929: low inflation — 1970-1980: low inflation — 2007-2014: low inflation.

'Low inflation' refers to annual inflation rates ranging from -1% to +2%. High inflation refers to annual inflation rates in excess of 4%. 'A period' refers to most years within the given dates (at least half of the time) and for most countries (at least 3 of 5 countries).

The period 1914-1929 was a period of post-war reconstruction, with government finances damaged by the first world war (especially Germany who was being forced to pay for the cost of the war), and goods and stock prices soaring. France and Germany experienced hyperinflation in the early 1920s. The period 1970-1980 was a period of two oil price shocks and lax monetary policy (in an attempt my governments to reduce unemployment). The period 2007-2014 was the period of the 'Great Recession', with countries (especially Europe and Japan) threatened by deflation.

Question 3

An economy experiences hyperinflation.

  1. The value of money falls very fast as prices fall very fast.
  2. The value of money falls very fast as prices rise very fast.
  3. The value of money rises very fast as prices fall very fast.
  4. The value of money rises very fast as prices rise very fast.
  5. The value of money could either rise or fall as prices rise very fast.
  6. The value of money is unchanged as prices rise very fast.

The 'value of money' refers to the purchasing power of a fixed nominal amount such as \$100.

A hyperinflation is defined as a period of large, sustained price rises, something like prices rising at an annualized rate of more than 50% for at least 6 months.

The most famous hyperinflation took place in Germany in 1923. In 1923, the rate of inflation reached 3.25 \(\times\) 10\(^{6}\) percent per month (prices double every 2 days). On 20 November 1923, the Rentenmark replaced the old mark at a rate of 1 to 10\(^{12}\).

In 1945-1946, Hungary experienced the worst hyperinflation on record. The peak inflation recorded was 1.3 \(\times\) 10\(^{16}\) percent per month (prices double every 15 hours). On 18 August 1946, the forint replaced the pengo at a rate of 1 to 4 \(\times\) 10\(^{29}\).

The most recent hyperinflation took place in Zimbabwe in 2008-2009, almost as extreme as Hungary, for an overall impact of 10\(^{25}\). Zimbabwe has abandoned its currency and now uses foreign currencies instead.

Question 4

The nominal interest rate is 3% and the inflation rate 2%.

  1. The real interest rate is 5%.
  2. The real interest rate is 4%.
  3. The real interest rate is 3%.
  4. The real interest rate is 2%.
  5. The real interest rate is 1%.
  6. The real interest rate is -1%.

The real interest rate is (approximately) equal to the nominal interest rate minus the inflation rate, \(0.03 - 0.02 = 0.01 = 1%\).

Question 5

The real interest rate is 3% and the inflation rate 2%.

  1. The nominal interest rate is 5%.
  2. The nominal interest rate is 4%.
  3. The nominal interest rate is 3%.
  4. The nominal interest rate is 2%.
  5. The nominal interest rate is 1%.
  6. The nominal interest rate is -1%.

The nominal interest rate is (approximately) equal to the real interest rate plus the inflation rate, \(0.03 + 0.02 = 0.05 = 5%\).

Question 6

The real interest rate is 3% and the nominal interest rate 2%.

  1. The inflation rate is 5%.
  2. The inflation rate is 4%.
  3. The inflation rate is 3%.
  4. The inflation rate is 2%.
  5. The inflation rate is 1%.
  6. The inflation rate is -1%.

The inflation rate is (approximately) equal to the nominal interest rate minus the real interest rate, \(0.02 - 0.03 = -0.01 = -1%\).

Question 7

You deposit \$100 into an interest-bearing account. The Consumer Price Index (CPI) is 100. One year later, your balance is \$105 and the CPI is 105.

  1. The nominal interest rate is 5%, the inflation rate 5%, the real interest rate is 5%.
  2. The nominal interest rate is 5%, the inflation rate 0%, the real interest rate is 5%.
  3. The nominal interest rate is 5%, the inflation rate is 5%, the real interest rate is 0%.
  4. The nominal interest rate is 10%, the inflation rate 5%, the real interest rate is 5%.
  5. The nominal interest rate is 10%, the inflation rate 0%, the real interest rate is 5%.
  6. The nominal interest rate is 10%, the inflation rate 5%, the real interest rate is 0%.

The inflation rate is defined as the rate of growth of the CPI.

The CPI rises from 100 to 105, so the inflation rate is 5%. The balance rises from \$100 to \$105, so the nominal interest rate is 5%. The real interest rate is (approximately) equal to the nominal interest rate minus the inflation rate, \(0.05 - 0.05 = 0\).

Question 8

The market expects prices to fall at an annual rate of 1%. Unexpectedly prices fall by 2%. This redistributes real income...

  1. from borrowers to lenders by about 1% of loans outstanding.
  2. from lenders to borrowers by about 1% of loans outstanding.
  3. from borrowers to lenders by about 2% of loans outstanding.
  4. from lenders to borrowers by about 2% of loans outstanding.
  5. from borrowers to lenders by about 3% of loans outstanding.
  6. from lenders to borrowers by about 3% of loans outstanding.

Question 9

The market expects an annual rate of inflation of 2%. Inflation unexpectedly reaches 5%. This redistributes real income...

  1. from borrowers to lenders by about 2% of loans outstanding.
  2. from lenders to borrowers by about 2% of loans outstanding.
  3. from borrowers to lenders by about 5% of loans outstanding.
  4. from lenders to borrowers by about 5% of loans outstanding.
  5. from borrowers to lenders by about 3% of loans outstanding.
  6. from lenders to borrowers by about 3% of loans outstanding.

Question 10

A 'lender' deposits \$100 for one year into an interest-bearing account paying an annual interest rate of 10%. A 'borrower' takes a one-year loan for \$100 at the same bank at an annual interest cost of 11%. All interest payments are made at the end of the year, with no intermediate monthly payments. Both lender and borrower had expected an annual inflation rate of 8%, but instead the recorded inflation rate is 10%. The excess inflation operates a real redistribution...

  1. from borrower to lender of about \$0.2
  2. from lender to borrower of about \$0.2
  3. from borrower to lender of about \$2
  4. from lender to borrower of about \$2
  5. from borrower to lender of about \$2.2
  6. from lender to borrower of about \$2.2

Do not include the redistribution operated by the expected capital appreciation of the lender's deposit and expected cost of the loan for the borrower, as these are part of standard loan terms and are in accordance with the agreement entered by both parties.

At the end of the year, the lender receives a nominal payment of \$110, while the borrower makes a nominal payment of \$111 (the difference is the bank's profit). The market's inflation forecast error is +2% (= 0.02), the excess of recorded inflation over expected inflation — thus, unexpected inflation reduces the real value of the lender's end-of-year balance by 2%, and reduces the real value of the borrower's end-of-year repayment by 2%. The lender suffers an unexpected real loss of 0.02 \(\times\) \$110 = \$2.2 (less than capital appreciation, so the lender's capital does not shrink in real terms). The borrower experiences an unexpected real gain of 0.02 \(\times\) \$111 = \$2.22 (less than the cost of the loan, so the borrower does not get money for free).