Week 3 Money, banking, prices and monetary policy

Question 1

Does money directly yield utility?

Answer 1

No, it is merely a “veil” which enables the purchase of items which do.

Question 2

How does money play a role in our economic activity?

Answer 2

By facilitating exchange.

Question 3

Give 3 features of a simple monetary model

Answer 3

• Time is discrete and we have an infinite number of periods (t = 1, 2, . . . , ∞)
• In each period (bar the first one) there are two generations of agents: young and old, each of size N.
• Agents live for two periods (young and old) and they are all identical within their group

Question 4

In a simple monetary model, what is 1 key feature about the total population size?

Answer 4

It remains constant.

Question 5

In a simple monetary model, what is the total population size?

Answer 5

2N

Question 6

Give 6 assumptions a simple monetary model

Answer 6

• Agents value leisure when young and consumption when old
• The initial old are endowed with an initial money supply M (so M/N per old) euros
• The initial old value consumption (but not money) so they would like to trade M/N for goods, but with whom?
• The young are not endowed with money but can produce output via y = z(1 − l) but they only value l; they will value consumption when old
• Can summarise this as u(l, c)
• The output is non-storable

Question 7

So what do young agents value In a simple monetary model?

Answer 7

Leisure, until they are old, when they will value consumption

Question 8

In a simple monetary model, what does the output being non-storable mean?

Answer 8

A young person cannot produce something, and store it until they are old and consume it then.

Question 9

In a simple monetary model, if the price of output (in euros) is pt, what does a higher price mean?

Answer 9

Money has less purchasing power.

Question 10

In a simple monetary model, if agents are going to accept money as medium of exchange, what must be true?

Answer 10

If agents are going to accept money as medium of exchange, it must have value: pt < ∞ (ie money isn’t worthless) ∀t

Question 11

In a simple monetary model what is the production function for the representative young agent?

Answer 11

y = z(1-L)

Question 12

In a simple monetary model, as the young person doesn’t value their output, what is the best they can do?

Answer 12

Sell it to the current old for money.

Question 13

In a simple monetary model, if price of good in euros is pt, what does a young person budget constraint ( mt)=?

Answer 13

mt = ptz(1 − l)

Question 14

In a simple monetary model, as people only purchase goods when they’re elderly, what is an old person’s budget constraint?

Answer 14

mt= pt+1 *c

Question 15

In a simple monetary model, by combining the 2 constraints, we get the agents lifetime budget constraint for a given p. What is this?

Answer 15

c =(pt/pt+1)*z(1 − l)

Question 16

What does Πt+1 stand for?

Answer 16

The inflation rate

Question 17

In stationary equilibria, what do we have for variables that (may) grow?

Answer 17

Constant growth rates

Question 18

When (l,c) is chosen to maximise u(l,c), what is this subject to?

Answer 18

c=Π^−1*z(1 − l)

Question 19

Draw The Demand for Real Money Balances graph.

Answer 19

Check notes for answer

Question 20

What is the demand for nominal money balances equation?

Answer 20

mtD = ptz(1-ld)

Question 21

What is the demand for real money balances equation?

Answer 21

(mD/pt) = z(1-lD)

Question 22

What does Π stand for?

Answer 22

The expected rate of inflation

Question 23

If (mDt/pt) = z(1-lD), why does qD = z(1-lD),

Answer 23

As qt is identical to mt/pt

Question 24

What does qD = qD(z,Π) imply?

Answer 24

Demand for real money balances only depends on technology and the expected rate of inflation

Question 25

What are the effects of an increase in Π?

Answer 25

• The horizontal intercept is unchanged: if you do not work, you do not consume
• But receiving M today will purchase less in the next period so the BC becomes flatter
• As the slope changes, we therefore have IE and SE
• qD will also be affected (assume SE > IE) so qD falls

Question 26

What are the effects of an increase in z?

Answer 26

An increase in z is exactly the opposite of our results above, except that there is also a direct effect of z on qD.

Question 27

What are the real world interpretations of an increase in Π?

Answer 27

• An increase in expected inflation causes a movement away from activities that rely on cash towards non-cash sectors
• An increase in expected inflation causes a movement towards non-market activities

Question 28

What is monetary demand given by?

Answer 28

The demand is given by qD(z, Π) (real) per young, NqD(z, Π) in total.

Question 29

What is monetary supply given by?

Answer 29

The supply is M/pt (held by the old)

Question 30

So therefore what is the equation for money market equilibrium?

Answer 30

M/pt= NqD(z, Π)

This must hold every period, including t + 1

Question 31

If inflation is 5%, what is Πt? What if its 0%?

Answer 31

5% Π=0.05

0% Π=1

Question 32

If pt+1 = pt, what does that imply about Π?

Answer 32

That Π=1, as the price level is remaining constant.

Question 33

What is significant about this equation describing the initial old’s consumption: c0*=M/Np1=qD(z, 1)?

Answer 33

The initial old’s consumption is determined by the amount of output the young are willing to produce in exchange for money, qD(z, 1)

Question 34

What does each young agent therefore work and what do they produce?

Answer 34

• Each young agent works n∗ = 1 − lD(z, 1)
• Producing y∗ = zn∗
• This is exchanged for q∗:
• c∗ = y∗ = q∗ = qD(z, 1)

Question 35

What is the role of money in this simple model?

Answer 35

If money didn’t exist in this model, young people wouldn’t be able to trade with the old, so l would =1 and C would = 0

Question 36

Is welfare higher under autarchy or in the monetary equilibrium?

Answer 36

The Monetary Equilibrium

Question 37

Why can’t we have trade between young and old in the overlapping generations model?

Answer 37

As the old will not be there to fulfil their promises

Question 38

Will a change in the quantity of money have any real effects?

Answer 38

No, all real variables will remain unaffected as a 1 off increase in M won’t effect anything real and only nominal values:
pt+1M/ptM = NqD(Z,Π)/NqD(Z,Π)

Question 39

Does a growth in the money supply cause a change in any real variables?

Answer 39

No as Π∗ = µ

Question 40

What would doubling µ do?

Answer 40

Double the inflation rate