Monetary and Banking Economics-Spring 2020

Assignment 2
by Qing Liu and Wenlan Luo

Note: The due date for this assignment is on March 25,2020(Collected

on Web Learning System). Late submission is unacceptable.

Champ and Freeman(Fourth Edition), Chap4, 3.2;3.5;4.1;4.4;4.6;4.7;4.8;4.9

Exercise 3.2 Consider a commodity money model economy like the one de-
scribed in this chapter but with the following features: There are 100 identical
people in every generation. Each individual is endowed with 10 units of the con-
sumption good when young and nothing when old. To keep things simple, let us
assume that each young person wished to acquire money balances worth half of
his endowment, regardless of the rate of return. The initial old own a total of
100 units of gold. Assume that individuals are indifferent between consuming 1
unit of gold and consuming 2 units of the consumption good.
(a) Suppose the initial old choose to sell their gold for consumption goods
rather than consume the gold. Write an equation that represents the equal-
ity of supply and demand for gold. Use it to find the number of units of
gold purchased by each individual, mgt , and he price of gold, vtg
(b) At this price of gold, will the initial old actually choose to consume any of
their gold?
(c) Would the initial old chose to consume any of their gold if the total initial
stock of gold were 800? In this case, what would be the price of gold and
the stock of gold after the intial old consumed some of their gold? Compare
your answer in this part with your answer in part a. Does the quantity
theory of money hold?
(d) Suppose it is learned that a glod discovery will increase the stock of gold
from 100 units to 200 units in period t∗ . Assume the government uses
the newly discovered gold to buy bread that will not be given back to its
citizens. Find the price of gold at t∗ − 1 and at t∗ . Also find the rate of
return of gold acquired at t∗ − 1
Exercise 3.5 Consider again the model economy described in Exercise 3.2, but
suppose there is a second storable good: silver. Silver is as easy to exchange and
store as gold. The initial old own a total of 50 units of silver. There can be no
additions to the stock of silver. Individuals are indifferent between consuming 1
unit of silver and 1 unit of consumption good. Let v tsdenote the trading value
of a unit of silver.

(a) Find the market-clearing condition if both silver and gold are used as
money. Can there be an equilibrium in which both silver and gold are
used only as money(are not consumed) and vts = 1.5?...2? In each case,

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 use the market-clearing condition to find the corresponding trading value
of gold. For what range of values of vts is there an equilibrium in which
both silver and gold are used only as money(are not consumed)?
(b) What would happen to the value of silver if the government passed a law
banning the use of gold as money?
(c) If one member of the initial old owned the entire stock of silver, would that
person prefer that gold alone, silver alone, or both gold and silver be used
as money? Explain
(d) If each member of the initial old owned 0.5 unit of silver and 2 units of
gold, would the initial old prefer that gold alone, silver alone, or both gold
and silver be used as money? Explain
Exercise 4.1 Let Nt = nNt−1 and Mt = zMt−1 for every period t, where z and
n are both greater than 1. The money created each period is used to finance a
lump-sum subsidy of a∗t goods to each young person.
(a) Find the equation for the budget set of an individual in the monetary
equilibrium. Graph it. Show an arbitrary indifference curve tangent to
the set and indicate the levels of c1 and c2 that would be chosen by an
individual in this equilibrium.
(b) On the graph you drew in part a, draw the feasible set. Take advantage
of the fact that the feasible set line goes through the monetary equilibrium
(c∗1 , c∗2 ). Label your graph carefully, distinguishing between the budget and
feasible sets.
(c) Prove 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 sets.
Exercise 4.4 Consider the following economy: Individuals are endowed with
y units of the consumption good when young and nothing when old. The fiat
money stock is constant. The population grows at rate n. In each period, the
government taxes each young person τ goods. The total proceeds of the tax are
then distributed equally among the old who are alive in that period.
(a) Write down the first- and second- period budget constraints facing a typ-
ical individual at time t. Combine the constraints into a lifetime budget
constraint.
(b) Find the rate of return on fiat money in a stationary monetary equilibrium
(c) Does the monetary equilibrium maximize the utility of future generations?
(d) Does this government policy have any effect on an individual’s welfare?
(e) Does your answer to part d change if the tax is larger than the real balances
people would choose to hold in the absence of the tax?

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 (f) Suppose that tax collection and redistribution are(very) costly, so that, for
every unit of tax collected from the young, only 0.5 unit is available to
distribute to the old. How does your answer to part d change?
Exercise 4.6 Assume that people face a lump-sum tax of τ goods when old and
a rate of expansion of the fiat money supply of z > 1. The tax and the expansion
of the fiat money stock are used to finance government purchases of g goods per
young person in every period. There are N people in every generation.
(a) Find the individual’s budget constraints when young and when old. Com-
bine them to form the individual’s lifetime budget constraint and graph
this constraint.
(b) Find the government’s budget constraint.
(c) Graph together the feasible set and the stationary monetary equilibrium.
(d) Find the stationary monetary equilibrium when z = 1 and add it to the
graph in part c
(e) Use a ruler on your graph to compare the real balances of fiat money when
z > 1 to the values when z = 1.
Exercise 4.7Assume that the utility function of people in the economy described
in Exercise 4.6 is log(c1,t ) + log(c2,t+1 )
(a) Find the real demand for money (q = vt mt ) as a function of z and τ .
Hint: See appendix to Chapter 1 for a discussion for solution techniques.
(b) Find the government budget constraint in a stationary equilibrium. Solve
it for τ as a function of z(The expression will also involve y and g)
(c) Substitute your expression of τ from the government budget constraint(part
b) into the demand for money(part a). Use this to represent seigniorage as
a function of z alone. Graph Seigniorage as a function of z. For the graph,
use the following parameter values: N = 1000, y = 100, and g = 10.
Exercise 4.8 Consider an economy with a constant population of N = 1000.
Individuals are endowed with y = 20 units of the consumption good when young
and nothing when old. All seigniorage revenue is used to finance government
expenditures. There are no subsidies and no taxes other than seigniorage. Sup-
pose that preferences are such that each individual wishes to hold real balances
of fiat money worth 1+ yvt goods.
vt+1

(a) Use the equality of supply and demand in the money market to find the
total real balances of fiat money in a stationary equilibrium as a function
of the rate of fiat money creation z
(b) Use your answer in part a to find total seigniorage revenue as a function
of z. Graph this function and explain its shape

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Exercise 4.9 Suppose the monetary authority prints fiat money at the rate z
but now does not distribute the newly printed money as a lump-sum subsidy.
Instead, the government distributes the newly printed money by giving each old
person α new dollars for each dollar acquired when young. Assume that there
is a constant population of people endowed only when young.

(a) Use the government budget constraint to find α as a function of z.

(b) Find the individual’s budget constraints when young and old. Combine
them to form the individual’s lifetime budget constraint.
(c) What is the inflation rate pt+1 /pt ? What is the real rate of return on fiat
money? Hint: the real rate of return on a unit of fiat money is not simply
vt+1 /vt in this case.
(d) Compare the individual’s lifetime budget constraint with the feasible set.
Demonstrate that the monetary equilibrium satisfies the golden rule re-
gardless of the rate of inflation. Explain why inflation does not induce
people ot reduce their real balances of fiat money in this case.