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LSE Economics Department EC210 Macroeconomic Principles 2013/2014 Michaelmas Term

Kevin Sheedy 32L.1.09, x5022

Problem Set 9: The Dynamic Macro Model and an Introduction to Money

1. Creative destruction : Consider permanent positive shocks to TFP that represent technological innovations. However, innovations are associated with a process of ‘creative destruction’. In other words, when an innovation occurs, a portion of the existing capital stock designed to work with the old technology is rendered obsolete and becomes useless. Describe the effects of such a shock. Are they consistent with the business cycle facts? 2. Double coincidence of wants : Suppose that there are three individuals in the economy with the following consumption and production characteristics. The first person needs a haircut and provides massages, the other wants a guided tour through the city and can provide a haircut, and the third agent badly needs a massage and can give city tours. a. Why is this an example of the absence of double coincidence of wants? b. Assume now that person 2 can sew a T-shirt instead of providing a haircut, and person 1 wants a T-shirt instead of a haircut. Show that it is now possible for trade to take place. Carefully explain the difference to part (a). c. Finally, replacing T-shirts with haircuts again, determine who trades what with whom if fiat money is used in exchange. 3. Credit card taxes : Suppose the government decides that the use of credit cards is bad and introduces a tax on credit-card balances. That is, if a consumer or firm has a credit-card balance of X (in real terms), he or she is taxed tX , where t is the tax rate. Determine the effects on the equilibrium price and quantity of credit-card balances, the demand for money, and the price level. Explain your results.