Pontificia Universidad Católica de Chile

Facultad de Ciencias Económicas y Administrativas

March 23, 2018

Midterm exam 1 - Solution

Macroeconomı́a II

Question 1 (1 point)
Answer TRUE or FALSE to the following statements. You do not need to justify your
answers, but there is a penalty for wrong answers: every two items you answer
incorrectly cancels one item you answered correctly (as long as you have items
answered correctly to cancel, of course). Therefore, 1 mistake costs you nothing; 2 or
3 mistakes costs you 1 right item; 4 mistakes costs you 2 right items. Thus, it may be
optimal not to answer some questions if you are not sure.

1. In an economy in which people only use currency to make transactions, the money
multiplier is zero. (1/6 points) F

2. According to the Baumol-Tobin model, an increase in the cost of going to the bank
will increase the elasticity of the money demand with respect to the interest rate.
(1/6 points) F

3. Suppose the velocity of money is constant in time. According to the quantitative

theory of money, a country with a positive growth rate of the money supply will
always have a positive inflation rate. (1/6 points) F

4. According to what you a read in a “Parable of Macroeconomics”, if all of a sudden

everyone has a desire to spend less, a decrease in the quantity of money makes
everyone better off, by adjusting the quantity of money to the lower level of desired
spending. (1/6 points) F

5. When the central banks buys $50 in bonds from the public and at the same time
buys $50 in foreign exchange, the monetary base increases. (1/6 points) T

6. Suppose a country has a money demand function M d /P = κy, where κ > 0 is a

constant parameter and y is real income (y is exogenous does not depend on the
money demand). Thus, a higher κ implies a lower velocity of money. (1/6 points) T

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Question 2 (1 point)
Suppose an economy has two types of deposits: demand deposits (Dv ) and savings deposits
(Dp ). We define the money aggregate M 1 as the sum of demand deposits and currency
(C), that is, M 1 ≡ Dv + C. We define the money aggregate M 2 as M 2 ≡ M 1 + Dp .
The monetary base is given by H ≡ C + R, where R denote total reserves in the banking
sector. The total amount of deposits D is given by D ≡ Dv + Dp . Assume agents always
keep a ratio of currency (C) to total deposits (D) equal to 1/4, that is:

C 1
= .
D 4

Moreover, the ratio of demand deposits to total deposits and savings deposits to total
deposits is constant and given by

Dv 3 Dp 1
= and = .
D 4 D 4

Banks keep a ratio of reserves (R) to total deposits equal to some number θ ∈ (0, 1):

R
= θ.
D

1. Compute the M 1 money multiplier (that is M 1/H) as a function of θ. (1/3 points)

The definition of M 1 and H are:

M 1 = Dv + C (1)

and

H = C + R. (2)

C Dv R
Dividing (1) by (2), manipulating and using D
= 14 , D
= 3
4
and D
= θ:

M1 Dv + C Dv /D + C/D 3/4 + 1/4 1

= = = =
H C +R C/D + R/D 1/4 + θ 1/4 + θ

2. Compute the M 2 money multiplier (that is M 2/H) as a function θ. (1/3 points)

The definition of M 2 is:
M 2 = M 1 + Dp

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 Which using the definitions of M 1 and D becomes

M2 = D + C (3)

and

H = C + R. (4)

C 1 R
Dividing (3) by (4), manipulating and using D
= 4
and D
= θ:

M2 D+C D/D + C/D 1 + 1/4

= = =
H C +R C/D + R/D 1/4 + θ

3. Find a condition that implies a M 1 money multiplier smaller than one. (1/3 points)
M1
To get H
< 1 we need:
1
< 1 ⇒ θ > 3/4.
1/4 + θ

Question 3 (2 points)
Consider an economy in which there is a single good that can be used as capital or for
consumption. Time is discrete and indexed by t ∈ {−1, 0, 1, 2, ...}. Consider the following
problem of the representative household:
∞
X
max β t u (ct )
{ct ,kt ,Bt ,Mt }t≥0
t=0

s.t. Pt ct + Pt kt + Bt + Mt = Pt f (kt−1 ) + (1 + it−1 )Bt−1 + Mt−1 + (1 − δ)Pt kt−1 + Tt , ∀t ≥ 0

ψPt ct ≤ Mt−1 + Tt , ∀t ≥ 0
k−1 = k > 0, B−1 = B > 0, M−1 = M > 0
lim (Bt /Pt ) = 0,
t→∞

kt , ct , Mt ≥ 0, ∀t ≥ 0.

The notation is standard and is the same used in class: u(c) is the instantaneous utility
function; f (k) is the production function; Pt denotes the price of the good at date t; Bt is
the nominal amount of bonds the household chooses to hold at date t; Mt is the quantity
of money he chooses to carry from date t to date t + 1; it is the nominal interest rate
between dates t and t + 1; ct is the household consumption at date t; kt is the amount of

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capital he carries from date t to t + 1; Tt are cash transfers received at date t; β ∈ (0, 1)
is the discount factor and δ ∈ (0, 1) is the depreciation rate of capital. Define bt ≡ Bt /Pt ,
mt ≡ Mt /Pt , πt ≡ (Pt − Pt−1 )/Pt−1 ,τt ≡ Tt /Pt and let rt denote the real interest rate
between dates t and t + 1.
The constraint ψPt ct ≤ Mt−1 is intepreted as a standard cash-in-advance constraint,
except that now only a fraction ψ ∈ (0, 1) of the household consumption is purchased
using cash.
In what follows, assume that u(·) and f (·) satisfy all the usual assumptions that guar-
antee an unique interior solution (and thus the non-negativity constraints kt , ct , Mt ≥ 0
never bind in the optimal choice and you can ignore them). Moreover, assume the cash-
in-advance constraint binds at all dates in the optimal solution (which is true if it > 0,
for every t ≥ 0). There is no uncertainty and the household takes as given the path of all
exogenous variables.

1. Rewrite the budget constraint and the cash-in-advance constraint in real units (that
is, in terms of only the real variables {ct , kt , bt , mt , rt , τt }t≥0 and the inflation rate
{πt }t≥0 ). (Tip: use the Fisher equation to get rid of nominal interest rates). (0.5
points)
Dividing the budget constraint by Pt :

Bt−1 Mt−1
ct + kt + bt + mt = f (kt−1 ) + (1 + it−1 ) + + (1 − δ)kt−1 + τt
Pt Pt

Rearranging:

Bt−1 Pt−1 Mt−1 Pt−1

ct + kt + bt + mt = f (kt−1 ) + (1 + it−1 ) + + (1 − δ)kt−1 + τt
Pt−1 Pt Pt−1 Pt

1 + it−1 mt−1
ct + kt + bt + mt = f (kt−1 ) + bt−1 + + (1 − δ)kt−1 + τt
1 + πt 1 + πt
And using the Fisher equation:

mt−1
ct + kt + bt + mt = f (kt−1 ) + (1 + rt−1 ) bt−1 + + (1 − δ)kt−1 + τt
1 + πt

Similarly, we divide the CIA constraint by Pt and rearrange:

Mt−1
ψct ≤ + τt
Pt

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 Mt−1 Pt−1
ψct ≤ + τt
Pt−1 Pt
mt−1
ψct ≤ + τt
1 + πt

2. Denote by {λt }t≥0 the Lagrange multipliers associated to the budget constraint and
by {µt }t≥0 the Lagrange multipliers associated to the cash-in-advance constraint.
Write down the Lagrangian using the budget constraints in real units and derive the
first order conditions for ct , kt , bt and mt . (0.5 points)

The lagrangian is given by

∞
mt−1
  
t
X
L= β u(ct ) − µt ψct − − τt
t=0 1 + πt
mt−1
 
−λt ct + kt + bt + mt − f (kt−1 ) − (1 + rt−1 ) bt−1 − − (1 − δ)kt−1 − τt
1 + πt

The FOC with respect to ct is:

β t [u0 (ct ) − λt − µt ψ] = 0 (FOC1)

The FOC with respect to kt is:

−β t λt + β t+1 λt+1 [f 0 (kt ) + 1 − δ] = 0 (FOC2)

The FOC with respect to bt is:

−β t λt + β t+1 λt+1 (1 + rt ) = 0 (FOC3)

The FOC with respect to mt is:

β t+1
−β t λt + (µt+1 + λt+1 ) = 0 (FOC4)
1 + πt+1

3. In the optimal solution we get the following Euler equation:

u0 (ct )
= β (1 + rt ) h(it−1 , it , ψ)
u0 (ct+1 )

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 where h(it−1 , it , ψ) is a function of it−1 , it and ψ. Derive the functional form of
h(it−1 , it , ψ). (0.5 points)
Subtracting (FOC4) from (FOC3) and solving for µt+1 :

β t+1
β t+1 λt+1 (1 + rt ) − (µt+1 + λt+1 ) = 0
1 + πt+1

µt+1 = λt+1 [(1 + πt+1 ) (1 + rt ) − 1]

Thus, replacing µt = λt [(1 + πt ) (1 + rt−1 ) − 1] on (FOC1) we get:

u0 (ct ) − λt − ψλt [(1 + πt ) (1 + rt−1 ) − 1] = 0

Using the Fisher equation it becomes:

" #
0 1−ψ
u (ct ) = ψλt 1 + it−1 + (1)
ψ

Iterating (1) forward and dividing by (1):

h i
1−ψ
0
u (ct ) λt 1 + it−1 + ψ
0
= h
1−ψ
i
u (ct+1 ) λt+1 1 + it +
ψ

λt
But (FOC3) implies λt+1
= β (1 + rt ) and then:
 
1−ψ
u0 (ct ) 1 + it−1 + ψ
= β (1 + rt )   (2)
u0 (ct+1 ) 1 + it + 1−ψ
ψ

Thus,
1−ψ
1 + it−1 + ψ
h(it−1 , it , ψ) = 1−ψ .
1 + it + ψ

4. Intepret economically the Euler equation you found in the previous item when ψ = 1.
(Tip: you may find useful to rearrange the equation before your interpret it.) (0.5
points)
When ψ = 1 we have:
u0 (ct ) β (1 + rt ) u0 (ct+1 )
= .
1 + it−1 1 + it

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 The LHS is the marginal benefit of one unit of consumption at date t divided by a
function of the opportunity cost of consuming at t (which is the foregone interest
it−1 that the agent has to incur by buying less bonds and carrying more money at
t − 1). The RHS is the marginal benefit of consuming at date t + 1 divided by a
function of the opportunity cost of consuming at t + 1 (which is the foregone interest
it that the agent has to incur by buying less bonds and carrying more money at t).
For the agent to be indifferent between consuming at both dates, this “cost-benefit”
ratio must be equal.

Question 4 (1 point)
In the money in the utility function model (without labor) seen in class, we have shown
under the optimal choice of money and consumption, the following equation holds:

um (ct , mt ) it
= , (1)
uc (ct , mt ) 1 + it

where um (ct , mt ) and uc (ct , mt ) denote the marginal utility of real money balances (mt )
and consumption (ct ), respectively, and it denotes the nominal interest rate. We also know
that the household choice satisfies a standard Euler equation:

uc (ct , mt ) = β (1 + rt ) uc (ct+1 , mt+1 ). (2)

1. Show that the household choice satisfies:

it
um (ct , mt ) = βuc (ct+1 , mt+1 ).
1 + πt+1

Interpret this equation. (0.5 points)

Using the Fisher equation, (1) becomes:

it
um (ct , mt ) = uc (ct , mt )
(1 + rt ) (1 + πt+1 )

Using (2) we get:

it it
um (ct , mt ) = (1+r
β t )uc (ct+1 , mt+1 ) = βuc (ct+1 , mt+1 )
(1+ rt ) (1 + πt+1 )
  
1 + πt+1

The intuition is the following. In equilibrium, the household must be indifferent

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 between having more money today or consuming tomorrow. If she gives up holding
one unit of money at t, she gets it extra dollars at t + 1, which implies a real
increase of 1+πitt+1 in the amount of goods she can buy. Thus, her utility increases by
it
1+πt+1
βu0 (ct+1 , mt+1 ). For her to be indifferent, this must be equal to the marginal
utility of holding money today.

2. Assume that u(c, m) = ln c−(m−5)2 . What is the nominal interest rate and inflation
rate that maximize the representative household utility in the steady state? If the
nominal interest rate is chosen to maximize the household’s utility at the steady
state, how much money is demanded at the steady state? Provide an intuition for
the optimal nominal interest rate. (Tip: remember that money is superneutral in
this model.) (0.5 points)

Since consumption is independent of the monetary side of the economy, we maximize

the household utility by maximzing his utility of holding money. Since u(·) is concave
in m, this happens when um (c, m) = 0. Thus, (1) implies that interest rate that
maximizes the household utility in the steady state is:

iss
0= ⇒ iss = 0
1 + iss

The Fisher equation implies that

1 + iss = (1 + rss ) (1 + π ss )

And thus, the steady state welfare maximizing inflation is 1 + π ss = 1+r1 ss ⇒ π ss =

rss ss
− 1+r ss . The money demand when i = 0 is given by um (css , mss ) = 0, implying
mss = 5.

The intuition for it = 0 being optimal is the following. The opportunity cost of
holding money is the nominal interest rate (it is the “price” of money). The marginal
cost of producing money is zero. Efficiency implies that price equals the marginal
cost, thus it = 0.

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Question 5 (1 point)
Consider the basic Cagan’s model in which the log of the price level (pt ) and the log of
the money supply (mt ) satisfy the following difference equation:

mt − pt = −η (pt+1 − pt ) (1)

where is a constant larger than zero. For simplicity, suppose that mt is constant and equal
to m̃, for every t. We know that a solution to (1) is given by

∞
!i
1 X η
pt = mt+i = m̃
1 + η i=0 1 + η

The solution above is called the fundamental solution, but we know that there are other
solutions to (1). Answer the questions below:

1. Propose another (non-fundamental) solution and show that it also satisfies (1). (0.5
points)
Guess a solution of the form
pt = m̃ + b0 g t .

Plugging into (1):

 
−b0 g t = −η b0 g t+1 − b0 g t

Solving for g:

1+η
g=
η
Thus, !t
1+η
pt = m̃ + b0
η
is a solution to (1).

2. Discuss the economic intuition behind the non-fundamental solutions in which prices
increase over time, even though the money supply is constant. (Tip: you may want to
start with “Suppose everyone expects prices to increase a lot in the future. Then...”).
(0.5 points)
The idea is for this kind of equilibrium is the following: suppose people expect pt
to rise in the future (b0 > 0). Then, the Fisher equation implies that the nominal

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 interest rate will be high, reducing agents incentives to hold money. But then, there
is too little money demand for too much money supply, and prices have to increase
to equate the demand and the supply for real balances. But this confirm agents
initial expectations (a self-fullfiling prophecy).

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