Tutorial assignment: week 9 2022
Answer guide
1. What is the difference between nominal and real economic variables, and why is this
difference important for monetary policy?
Nominal: any variable whose scale is proportionate to the general price level. Examples: prices of
individual goods and services, incomes measured in dollars. Anything that would double if the
overall price level in the economy were to double.
Real: Everything else. Any variable whose scale of measurement is not affected by a change in the
price level. Examples: quantities of production, number of persons employed, relative prices
Economic significance for monetary policy: Classical theory asserts that
In the long run, monetary policy can only influence nominal variables. Hence it can
determine the price level and therefore also the inflation rate
Therefore monetary policy should focus mainly on inflation control
Economic well-being derives from real variables – if prices and wages were to double I would
be no better or worse off.
2. For each of the following, state whether it is a real or a nominal variable and give your
reason:
(a) The total value of Australia’s annual wheat crop
Nominal: it would double if all prices in the economy were to double
(b) The number of weeks’ of average wages it takes to buy a car
Real: it would be unaffected by a general doubling of prices and wages
(c) Average weekly income per household
Nominal: It would double if all prices and wages doubled
(d) The price of a litre of fuel
Nominal: It would double if all prices and wages doubled
3. If inflation is bad, why do inflation targeting countries generally set their targets as low
positive numbers rather than aiming at zero?
Four reasons for this were given in the lecture:
, Cost/benefit considerations. A deliberate inflation-reduction strategy is generally
regarded as costly. If you start from a situation where inflation and inflation
expectations are too high, it will take a period of higher than normal interest rates to
squeeze inflation out of the system. This is likely to mean a temporary period of higher
than normal unemployment. Policy makers may make the judgment that inflation is not
very harmful once it has been reduced to low single figures, and so it’s not worth the
extra cost of pushing it all the way down to zero.
Downward nominal rigidities. Flexibility in relative prices is good for economic efficiency.
It allows the economy to respond to changing supply/demand conditions in individual
markets. However, some variables in the economy are said to be subject to ‘downward
nominal rigidity’ – they don’t easily fall in nominal terms. Many wage rates would fall
into this category, as well as things rents that are governed by long-term contracts, or
amounts of debt owing. If any of these need to fall in relative terms to maintain market
equilibrium, this can more readily happen in an environment where there is some
inflation. They can fall in real or relative terms just by not rising as fast as the general
price level.
The zero interest bound. Monetary policy becomes more difficult to manage when the
zero interest bound is hit. This is less likely to occur if the inflation rate being targeted is
above zero, because then the average level of nominal interest rates would also be
higher. Any cut in interest rates in response to an economic downturn would be starting
from a higher level.
Measurement bias in inflation. Statistical research suggests that there is some bias in the
measurement of inflation, such that the true inflation rate on average is a bit less than
the measured rate. An example of the possible sources of bias would be product quality
improvement. Eg, if the price of a new car goes up by 10 per cent over a period of time,
part of that increase is a reflection of quality improvement – the price of a car of exactly
unchanged characteristics would have Increased by less, but this is not observable,
because technical improvement are continuously occurring. Official statistics do try to
make allowance for this, but some bias probably remains. In the US, early estimates of
this bias were around 1 per cent per annum, so a 1 per cent official inflation rate would
be consistent with price stability after allowing for measurement bias.
4. Give a brief summary of Milton Friedman’s views on what monetary policy can and cannot
do.
Friedman started with the cannot, and then went on to the can.
Cannot do
Permanently lower the level of interest rates
Permanently raise output and employment above levels that would otherwise prevail
Answer guide
1. What is the difference between nominal and real economic variables, and why is this
difference important for monetary policy?
Nominal: any variable whose scale is proportionate to the general price level. Examples: prices of
individual goods and services, incomes measured in dollars. Anything that would double if the
overall price level in the economy were to double.
Real: Everything else. Any variable whose scale of measurement is not affected by a change in the
price level. Examples: quantities of production, number of persons employed, relative prices
Economic significance for monetary policy: Classical theory asserts that
In the long run, monetary policy can only influence nominal variables. Hence it can
determine the price level and therefore also the inflation rate
Therefore monetary policy should focus mainly on inflation control
Economic well-being derives from real variables – if prices and wages were to double I would
be no better or worse off.
2. For each of the following, state whether it is a real or a nominal variable and give your
reason:
(a) The total value of Australia’s annual wheat crop
Nominal: it would double if all prices in the economy were to double
(b) The number of weeks’ of average wages it takes to buy a car
Real: it would be unaffected by a general doubling of prices and wages
(c) Average weekly income per household
Nominal: It would double if all prices and wages doubled
(d) The price of a litre of fuel
Nominal: It would double if all prices and wages doubled
3. If inflation is bad, why do inflation targeting countries generally set their targets as low
positive numbers rather than aiming at zero?
Four reasons for this were given in the lecture:
, Cost/benefit considerations. A deliberate inflation-reduction strategy is generally
regarded as costly. If you start from a situation where inflation and inflation
expectations are too high, it will take a period of higher than normal interest rates to
squeeze inflation out of the system. This is likely to mean a temporary period of higher
than normal unemployment. Policy makers may make the judgment that inflation is not
very harmful once it has been reduced to low single figures, and so it’s not worth the
extra cost of pushing it all the way down to zero.
Downward nominal rigidities. Flexibility in relative prices is good for economic efficiency.
It allows the economy to respond to changing supply/demand conditions in individual
markets. However, some variables in the economy are said to be subject to ‘downward
nominal rigidity’ – they don’t easily fall in nominal terms. Many wage rates would fall
into this category, as well as things rents that are governed by long-term contracts, or
amounts of debt owing. If any of these need to fall in relative terms to maintain market
equilibrium, this can more readily happen in an environment where there is some
inflation. They can fall in real or relative terms just by not rising as fast as the general
price level.
The zero interest bound. Monetary policy becomes more difficult to manage when the
zero interest bound is hit. This is less likely to occur if the inflation rate being targeted is
above zero, because then the average level of nominal interest rates would also be
higher. Any cut in interest rates in response to an economic downturn would be starting
from a higher level.
Measurement bias in inflation. Statistical research suggests that there is some bias in the
measurement of inflation, such that the true inflation rate on average is a bit less than
the measured rate. An example of the possible sources of bias would be product quality
improvement. Eg, if the price of a new car goes up by 10 per cent over a period of time,
part of that increase is a reflection of quality improvement – the price of a car of exactly
unchanged characteristics would have Increased by less, but this is not observable,
because technical improvement are continuously occurring. Official statistics do try to
make allowance for this, but some bias probably remains. In the US, early estimates of
this bias were around 1 per cent per annum, so a 1 per cent official inflation rate would
be consistent with price stability after allowing for measurement bias.
4. Give a brief summary of Milton Friedman’s views on what monetary policy can and cannot
do.
Friedman started with the cannot, and then went on to the can.
Cannot do
Permanently lower the level of interest rates
Permanently raise output and employment above levels that would otherwise prevail
