Intermediate Macroeconomics - Problem Set 6 Solutions

Question 1.

Question 2.

Question 3.

but the terms of lending are often fixed in nominal terms. When there is inflation, nominalinterest on previously bought bonds stays the same. Hence, real interest decreases, and richpeople are worse off.

In general, holders of nominal assets are hurt by inflation. Whether they are rich or poordepends on the structure of asset holdings in the economy. One should scrutinize politicians'statements when they claim to care about poor people.

F. Governments continue to print money because it is an easy source of revenue. Increasingmoney supply usually does not require a lengthy process of getting an approval from thelegislative branch. There are no costs of collecting and enforcing the inflation tax, which isa very important factor for less developed countries that are often unable to fight evasionfrom normal taxes, such as taxes on income, property, etc.

4. Savages

A. In the goods market, a temporary increase in productivity (an increase in A1 only) directly increases this period's aggregate supply (from AS0 to AS1 in Diagram 1) and income. Since workers have become more productive today relative to subsequent periods, their wages arehigher today relative to tomorrow. As an indirect effect, workers increase their supply oflabor, thereby shifting aggregate supply further to the right (from AS1 to AS2). Since the

increase in income is temporary, the demand for consumption Cd today increases less thantoday's income because of consumption smoothing motif. Remember that MPC out oftemporary income is less than one. Hence, aggregate demand shifts to the right less thanaggregate supply (from AD0 to AD1). As a result, equilibrium interest rate goes down, andequilibrium income and consumption go up.

Diagram 1

In the money market, both the increase in income and the decrease in interest rate cause the

Question 4.

money demand to increase: . See Diagram 2. Since the money supply is unchanged, the price level falls to restore equilibrium in the money market.

Diagram 2

To sum up, a temporary positive productivity shock increases output and consumption,reduces the real interest rate, and causes deflation--a drop in the price level.

B. In the goods market, a permanent increase in productivity (an increase in A1, A2, etc.) directly increases today's supply (from AS0 to AS1 in Diagram 3). There is no indirecteffect through labor supply because relative productivity A1/A2 and hence relative wages are unchanged. The demand for consumption today increases by the same amount as income(from AD0 to AD1) because a permanent increase in productivity implies a permanentincrease in output. Notice that MPC out of permanent income is one. Hence, equilibriuminterest rate is unchanged, but equilibrium income and consumption go up.

Diagram 3

In the money market, the effect is similar to the effect in Figure 2 but less pronounced. Theincrease in the money demand and the corresponding drop in the price level are only due tothe higher income.

In short, a permanent positive productivity shock increases output and consumption andcauses deflation, while leaving the interest rate unchanged. The effect on the interest rate isdifferent from part (A) because the increase in productivity occurs in all periods. Consumers do not have an incentive to save more today since tomorrow's income is goingto be higher as well. There is no excess supply of savings, and, therefore, banks do not haveto lower the interest rate to bring the supply of savings and the demand for loans inequilibrium.

5. Chief Powhatan

a. A temporary adverse productivity shock is just the opposite of a temporary positive shock.In the goods market, a decrease in A1 directly decreases this period's aggregate supply (fromAS2 to AS1 in Diagram 1) and income. Since workers have become less productive todayrelative to subsequent periods, their wages are lower today relative to tomorrow. As anindirect effect, workers decrease their supply of labor, thereby shifting aggregate supplyfurther to the left (from AS1 to AS0). Since the decrease in income is temporary, the

demand for consumption Cd today decreases less than today's income because ofconsumption smoothing motif. Hence, aggregate demand shifts to the left less thanaggregate supply (from AD1 to AD0). As a result, equilibrium interest rate goes up, whileequilibrium income and consumption go down.

In the money market, the decrease in income and the increase in interest rate cause themoney demand to decrease. See Diagram 2, but in the reverse direction. Since the moneysupply is unchanged, the price level rises to restore equilibrium in the money market.

Overall, a temporary adverse productivity shock causes stagflation in the classical model: output and consumption go down (stagnation), while prices go up (inflation).

b. If the Fed wants to prevent prices from rising, it needs to decrease the money supplyenough, so that the equilibrium between the reduced money demand and the money supplyoccur at the old price level P* (Diagram 4). Nothing else changes in the analysis becausemoney is neutral in the classical model.

Diagram 4

c. When one observes that money and real output are correlated, i.e. they move

Question 5.

simultaneously, one should not jump to the conclusion that the decrease in money causesoutput to decrease. The Fed knew about the decrease in output and deliberately acted todecrease the money supply. The change in money supply did not cause the change inoutput. Money is still neutral. Correlation and causation are not the same.

1. In the model that we saw in class, equilibrium price level is determined by the equality of nominal money supplyand nominal money demand. Persistent increases in prices can be caused either by persistent decreases in moneydemand or persistent increases in money supply. Decreasing money demand continuously requires decreasingreal output or transaction costs or increasing interest rate continuously. Such instances happen but not very often.Then the only plausible source of persistent increases in the price level is the growth in money supply. Therefore,inflation is said to be a monetary phenomenon.

2. Inflation is a tax because the real purchasing power of money held by consumers is reduced. The real value of gov-ernment outlays–purchases, transfers, etc.–is reduced. The government can print money and get resources fromthe private sector for free. The private sector pays this tax, specifically holders of nominal assets.

It is true that poor people tend to hold a larger percentage of their wealth as money. In this sense, they pay theinflation tax. On the other hand, rich people tend to hold a lot of bonds that pay a fixed nominal interest. In otherwords, people with high income save and lend, but the terms of lending are often fixed in nominal terms. Whenthere is inflation, nominal interest on previously bought bonds stays the same. Hence, real interest decreases, andrich people are worse off.

In general, holders of nominal assets are hurt by inflation. Whether they are rich or poor depends on the struc-ture of asset holdings in the economy. One should scrutinize politicians’ statements when they claim to care aboutpoor people.

3. When a government is under fiscal stress, i.e. its purchases of goods and services from the public consistently ex-ceed its tax revenues, the government is tempted to look for other sources of revenue. An easy source of revenue isprinting money. As we have seen before, increasing the money supply causes inflation. Therefore, fiscal problemsoften induce governments to increase the money supply, which in turn causes inflation.

When there is inflation, the real value of government debt goes down. That is, the government pays back to lendersless goods than with a lower inflation rate. Thus, inflation is a way to repudiate debt.

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Question 6.