NAME : Oscar Chipoka.

STUDENT ID : a1740567

TUTORIAL DAY : Wednesday. TIME: 1pm to 2pm

TUTORIAL NO : Two (2)

Exercise 1

Q1. There will be no difference in the rates of return of fiat money in the two economies.
This is because the two economies have the same population, supply of fiat money, quantity
of units of endowments, distribution of endowments (only to the young and nothing when
old), and they both have stationarity. This means that the slopes of the budget set lines (BSL)
for the two economies are identical. The slope of the BSL is the real rate of return of fiat
money.

Q2. There will be a difference in the value of money in the two economies because the two
economies are at different points of monetary competitive equilibrium, being the intersection
of the BSL and the indifference curves reflecting differences in preferences. Given that
individuals are operating in a deterministic environment characterised by rational
expectations and perfect foresight, the value of money in period t will be determined
exclusively and entirely by an infinite chain of expectations about its future value. Economy
B has a higher value of money because its quantity of young age consumption being given up
in equilibrium, namely y-c*1 in exchange for c*2, is larger than the quantity being given up in
economy A. Consequently, the quantity of old age consumption in period t+1 is larger in
economy B than economy one. This implies that individuals in economy B know that the
future value of money will be higher and hence increase their demand for money in the
current period.

Exercise 2

Q1. Derive the lifetime budget constraint

Step 1: derive the First Period Budget Constraint (FPBC)

c 1 ,t + v t mt ≤ y t …………………(1) where :

C1,t = young age consumption; vt = value of fiat money in period t; m t = nominal money
holdings in period t; vtmt = real money holdings in period t; y t= units of endowment of
consumption good in period t.

Step 2: derive the Second Period Budget Constraint:

vt+1mt ≥ c2,t+1 ………………………….(2) where

c2, t+1 = old age consumption at period t+1; v t+1= value of fiat money in period t+1 and is
assumed to be positive.

Step 3: Frome equation (2), we know that

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 c 2 ,t +1
Mt = ……………………….(3)
v t+1

Step 4: Substituting equation (3) into equation (1) to get the Lifetime Budget Constraint
gives:

C1,t +(vt/vt+1)c2,t+1 ≤ y …………………………(4) where (vt+1/vt ) is the one period gross real
rate of return of fiat money in real terms.

Q2. Real rate of return of fiat money in a monetary equilibrium

Stationarity assumption implies that c1,t = c1 and c2,t = c2 for all t ……………….(1)

Individual’s demand for fiat money when young in period t: y-c1,t ………………(2)

Aggregate Demand for Money in period t: Nt (y-c1,t) ………………………………(3)

Money Market Clearing Condition (supply = demand): vtMt=Nt(y-c1,t)…………………(4)

Solving for vt gives: vt = [Nt(y-c1,t)]/Mt …………………………………………….(5)

Also, at time t+1 : vt+1 = [Nt+1(y-c1,t+1)]/Mt+1 …………………………….………….(6)

Rate of return of money: vt+1/vt = [ (Nt+1(y-c1,t+1))/Mt+1] / [ (Nt(y - c1,t))/Mt] ………(7)

Stationarity of beliefs implies: vt+1/vt = [ Nt+1/Mt+1]/[ Nt/Mt] ……………………(8)

Assuming constant population and constant money supply implies that N t+1 =Nt and Mt+1 = Mt
respectively ………………………………………………………..(9).

Hence, the expression on the right-hand side would cancel out.

However, since the endowment is growing, yt+1 = αyt. Therefore, the rate of return of money
will be:
[vt+1 /vt ] = [ (αyt - c1) /(yt – c1) ] = α ……………………………………(10)
Hence the rate of return on money is equal to  which is also the same as the rate of growth
of the endowment. Since  > 1, the value of money is not constant, but is growing over time
with higher rate of return of money. As a result, the price of consumption good will be
declining overtime.

Question 2: Monetary Policy.

The overarching goal of monetary policy is to manage and influence the economic agent’s
expectations about the value of the national currency in order to preserve its value, maintain
low and stable inflation rate. The central bank uses conventional monetary policy instruments
like manipulating interest rate and conducting open market operations as well as using
unconventional monetary policy like quantitative easing and forward guidance to achieve its
goal of preserving the value of money. Since the Global Financial Crisis (GFC), standard

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tools of monetary policy had reached the zero lower bound of the interest rates and hence
could not be used to stimulate the economy even when there was need. Under those
circumstances, central banks used quantitative easing by buying long term bonds from the
market to increase the demand for bonds and hence the price and a reduction in their yields
(form of monetary expansion). Forward Guidance describes the use of monetary policy by
central banks in economies like Europe, Japan, USA, UK in form of giving bold speeches
about their intention for the future.

For example, during the Eurozone Financial Crisis of around 2011-2012, the Head of the
European Central Bank (ECB) Mario Draphi made a commitment that the ECB would buy
unlimited bonds from the market to preserve the euro and that he would do whatever it takes
to achieve that. Since the market considered this commitment as credible, the economy
improved tremendously without the ECB making any bond purchases. This is an excellent
example of forward guidance.

In the USA, they used a combination of quantitative easing and forward guidance to solve the
problem of high unemployment rate. The Fed created bank reserves to purchase $40 billion
monthly to buy mortgage-backed securities on top of purchasing treasury bills worth $45
billion monthly. QE3 was an open-ended purchase program until the bank saw substantial
improvement in the outlook of the labour market as it was aimed at creating market
confidence and maintain longer-term rates low. The Fed also indicated that unemployment
rate would have to reduce to 6.5 percent before the bank could even consider raising the
interest rates.