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ECOS3010: Tutorial 2 (Answer Key)
Question 1-5. Answer True, False or Uncertain. Briey explain your answer.
1. According to RBAs de
nition of monetary aggregates, M1 includes more assets than
M3 does.
False. According to RBAs de
nition of monetary aggregates, M3 includes M1 plus all
other deposits in the economy. So M3 includes more assets than M1 does.
2. Suppose that the government increases money supply and gives new money to the
old in every period. Comparing monetary equilibrium with the golden rule allocation, we
nd that all future generations achieve a lower level of utility but the initial old enjoys a
higher level of utility in the monetary equilibrium.
False. When the government increases money supply and gives new money to the old in
every period, the allocation in the monetary equilibrium is not the golden rule allocation. In
particular, all future generations in the monetary equilibrium achieve a lower level of utility.
The initial old also achieve a lower level of utility because c2 in the monetary equilibrium
is lower than c2 at the golden rule allocation.
3. Suppose that money supply grows at a constant rate z (z > 1). Comparing monetary
equilibrium and the golden rule allocation, we
nd that individuals consume too much when
young and too little when old in the monetary equilibrium.
True. In a monetary equilibrium, ination makes young individuals trade less goods
for money. As a result, the old have less money to purchase goods. Comparing monetary
equilibrium with the golden rule allocation, we
nd that individuals consume too much
when young and too little when old.
4. Suppose that the population grows at a constant rate n (n > 1) and money supply
grows at a constant rate z (z > 1), the value of money falls over time.
Uncertain. When the population grows at a constant rate n and money supply grows
at a constant rate z, we can derive moneys rate of return as vt+1=vt = n=z. If n < z, the
value of money falls over time. If n > z, the value of money increases over time. And if
n = z, the value of money stays constant.
5. When the population is growing,
xing the price level is the optimal policy.
False. When the population is growing, moneys rate of return is given by vt+1=vt = n=z.
The allocation in the monetary equilibrium is generally not the golden rule allocation. The
optimal policy requires that an individuals budget constraint is identical to the planners
resource constraint. It implies that we need z = 1 for a monetary equilibrium to achieve the
golden rule allocation. In this case, the value of money increases over time and the price
level actually falls over time.
(Note that for question 4 and question 5, my explanation uses the expression of vt+1=vt.
If you cannot memorize the exact expression of vt+1=vt, it is
ne to explain your answer in
words as long as the intuition is correct.)
6. Let Nt = nNt1 and Mt = zMt1 for every period t, where z and n are both greater
than 1. The money created each period is used to
nance a lump-sum subsidy of at goods
to each young individual.
(a) Find the equation for the budget constraint of an individual in the monetary equilib-
rium. Graph it. Show an arbitrary indi¤erence curve tangent to the budget constraint and
indicate the levels of c1 and c2 that would be chosen by an individual in this equilibrium.
An individuals
rst- and second-period budget constraints are
c1 + vtmt y + at and c2 vt+1mt:
1
Combining these two period budget constraints together, we derive the lifetime budget
constraint
c1 +
vt
vt+1
c2 y + at :
The value of money is derived from the money market clearing condition (when aggregate
money supply equals aggregate money demand),
Nt (y + a
c1) = vtMt ! vt = Nt (y + a
c1)
Mt
:
It follows that moneys rate of return is
vt+1
vt
=
Nt+1(y+ac1)
Mt+1
Nt(y+ac1)
Mt
=
Nt+1
Nt
Mt
Mt+1
=
n
z
:
We can update our budget constraint as
c1 +
z
n
c2 y + a:
Graphically, we can draw the budget constraint and label point A as the allocation
in a monetary equilibrium. The consumption bundle (c1; c2) at point A maximizes an
individuals utility subject to the budget constraint.
c1
c2
A
c*1
c*2
y+a
(y+a)n/z
(b) On the graph you drew in part (a), draw the resource constraint. Take advantage of
the fact that the resource constraint goes through the monetary equilibrium (c1; c2). Label
your graph carefully, distinguishing between the budget and resource constraints.
We
rst derive the resource constraint faced by the planner,
Ntc1 +Nt1c2 Nty ! c1 + 1
n
c2 y:
We add the resource constraint to the graph and label the golden rule allocation as point
B.
2
c1
c2
A
c*1
c*2
y+a
(y+a)n/z
B
ny
y
(c) Show that the monetary equilibrium does not maximize the utility of the future
generations. Support your assertion with references to the graph you drew of the budget
and feasible constraints.
We can clearly see from the graph that there are feasible points that are preferred by the
future generations to (c1; c2). One such point is point B which is the golden rule allocation.
Point B lies on a higher indi¤erence curve than (c1; c2). This shows that given the resource
constraint (or feasible constraint), the stationary monetary equilibrium (c1; c2) does not
maximize the utility of future generations. Furthermore, the initial old also prefer a point
like B since it gives them higher second-period consumption than c2.
(Note that we use the term "feasible constraint" and the term "resource constraint"
interchangeably.)
7. Consider an overlapping generations model with the following characteristics: Each
generation is composed of 1; 000 individuals. The money supply changes according toMt =
2Mt1. The initial old own a total of 10; 000 units of money (M0 = $10; 000). Each
period, the newly printed money is given to the old of that period as a lump-sum transfer.
Each individual is endowed with 20 units of the consumption good when born and nothing
when old. Preferences are such that individuals wish to save 10 units when young at the
equilibrium rate of return on money.
(a) What is the gross real rate of return on money in this economy (vt+1=vt)?
To derive the rate return on money, we
rst need to
nd the value of money. The money
market clearing condition is
N (y c1) = vtMt ! vt = N (y c1)
Mt
:
It follows that
vt+1
vt
=
N(yc1)
Mt+1
N(yc1)
Mt
=
Mt
Mt+1
=
1
2
:
The rate of return on money is 1=2. The value of money falls by a half every period.
(b) How many goods does an individual consume when young (c1)?
Individuals allocate their endowments between consumption and saving when young.
The
rst-period budget constraint is
c1 + vtmt y:
When individuals save 10 units when young, it means that vtmt = 10. Given that y = 20;
3
we have c1 = y vtmt = 10. The consumption when young is 10 units of good.
(c) How many goods does an individual receive as a transfer (a)?
From the government budget constraint, the transfer is from the newly printed money.
In aggregate,
Na = vt (Mt Mt1) = vt
Mt Mt
2
=
1
2
vtMt:
To
nd the value of vtMt, we use the money market clearing condition
vtMt = N (y c1) = 1000 (20 10) = 10; 000:
It follows that the amount of the transfer in real terms is given by
a =
1
2vtMt
N
=
1
2 10; 000
1000
= 5:
(d) How many goods does an individual consume when old (c2)?
From an individuals second-period budget constraint,
c2 vt+1mt + a:
Recall that vtmt = 10. We can derive the value of vt+1mt as
vt+1mt =
vt+1
vt
vtmt =
1
2
10 = 5:
Therefore, we have
c2 = vt+1mt + a = 5 + 5 = 10:
The second-period consumption is 10 units of good.
(e) What is the price of the consumption good in period 1 in dollars (p1)?