Maintaining the integrity of the money supply means keeping the price level (inflation) within

a tolerable range. The current target rate of inflation is about 2.5% for the annual increase in the All-Item Price Level. A rate of inflation that approaches zero is not possible without also seeing an unemployment rate higher than 4%. A. W. Phillips analyzed this problem by pointing out the inverse relationship between inflation and unemployment. The general idea is that as long as wages increase at about 2% to 3% per year, prices will rise by that amount as well as long as those workers are not more

productive. If productivity rises faster than wages, real incomes may also rise. As long as productivity does not increase but wages do, then inflation will also come close to the increase in wages and real income does not change. After all, a worker is not really entitled to a raise if his or her value to the company (productivity) does not increase to match the wage increase he or she desires. Raises are earned. Raises are not entitlements.

The money supply in the United States and most of the rest of the world is not a fixed amount.

No industrialized nations use a Gold Standard anymore. The amount of money in an economy

depends on decisions made by monetary authorities. In the United States the monetary

authorities are the people on the Board of Governors and the Federal Open Market Committee

of the Federal Reserve System (Page 294). Insofar as they are technically independent of

Congress and the President (Page 295) they can decide to change the amount of money in the

economy whenever they deem necessary.

Analyze the following scenarios using the Purchasing Power Equation on Page 291 of your text.

Explain your answers in paragraph form:

Scenario A:

The price level starts at 1.00 and rises by the end of the year to 1.15.

1. What has happened to the value of the dollar over that same period of time? (Calculation is required)
2. What are the consequences of that price level change (Pages 190+)?
3. Will an increase or decrease in the money supply reduce the price level to the tolerable range?

Scenario B:

The price level starts at 1.00 and falls by the end of the year to .90.

1. What has happened to the value of the dollar over that same period of time? (Calculation is required)
2. What are the consequences of that price level change (Pages 190+)?
3. Will an increase or decrease in the money supply increase the price level to the tolerable range?