Workbook PDF

Workbook - Macroeconomics II
Pontificia Universidad Católica de Chile
Professor: Caio Machado (caio.machado@uc.cl)

Teaching assistants: Wei Xiong (wxiong@uc.cl) and Diego Cussen (dcussen1@uc.cl)
This document contains all the exercises students are expected to try to solve in the
course. Solutions to all exercises but those market as “proposed” will be provided
during the semester. Moreover, the “proposed” exercises will not be solved during the
TA sessions. Students should be aware that simply understanding the solutions is not
enough to succeed in this course, so that I strong advise you put some effort into each
exercise before checking the solutions and going to the TA sessions. This file may be
updated during this semester. Make sure you have the latest version.
Last updated: June 6, 2019

Contents
1 Money supply 3
2 Money demand 8
3 Monetary equilibrium 22
4 Seignioriage 25
5 Exchange rates 29
6 Goods and money markets 32
7 IS-LM 35
8 Mundell-Fleming 43
9 Phillips curve 46
10 IS-LM-PC 49
11 AS-AD 53
12 Dynamic inconsistency 55
Macroeconomía II, 2019/1 2

1 Money supply
Exercise 1.1
[adapated from Mankiw] What are the three functions of money? Which of the func-
tions of money do the following items satisfy? Which do they not satisfy?
(a) A credit card;
(b) A painting by Rembrandt;
(c) A subway token;
(d) Bitcoins.
Exercise 1.2
[Mankiw] An economy has a monetary base of 1,000 $1 bills. Calculate the money
supply in scenarios 1-4 and answer part 5.
1. All money is held as currency.
2. All money is held as demand deposits. Banks hold 100 percent of deposits as
reserves.
3. All money is held as demand deposits. Banks hold 20 percent of deposits as re-
serves.
4. People hold equal amounts of currency and demand deposits. Banks hold 20
percent of deposits as reserves.
5. The central bank decides to increase the money supply by 10 percent. In each of
the above four scenarios, how much should it increase the monetary base?

Exercise 1.3
Suppose an economy has two types of deposits: demand deposits (Dv ) and savings
deposits (D p ). We define the money aggregate M1 as the sum of demand deposits and
currency (C), that is, M1 ≡ Dv + C. We define the money aggregate M2 as M2 ≡
M1 + D p . 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 + D p . 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 M1 money multiplier (that is M1/H) as a function of θ.
2. Compute the M2 money multiplier (that is M2/H) as a function θ.
3. Find a condition that implies a M1 money multiplier smaller than one.
Exercise 1.4
[Proposed] The graph below shows the M1 money multiplier for the US:

M1 Money Multiplier
2.2
2.0
1.8
1.6
Ratio 1.4
1.2
1.0
0.8
0.6
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Shaded areas indicate U.S. recessions Source: Federal Reserve Bank of St. Louis myf.red/g/iU0a
1. Provide one possible (theoretical) explanation for the multiplier being lower than
one.
2. Enter the FRED website (https://fred.stlouisfed.org/) and using the time series
for the monetary base and M2, compute the M2 money multiplier for the US.
3. Still on the FRED website, find data on:
(a) Excess reserves (e.g., “Excess Reserves of Depository Institutions”);
(b) Reserves (e.g., “Reserve Balances with Federal Reserve Banks”);
(c) Demand deposits (e.g., “Total Checkable Deposits”).
How does the data above helps you explain the fact that money multipliers have
remained very low after the Great Recession?
4. Read the article available on https://tinyurl.com/hd2zsxp and explain why US

banks excess reserves have increased so much in the last years.
Exercise 1.5
[Proposed] Imagine an economy with types of deposits only: demand deposits (Dv )
and savings deposits (D p ). Suppose the that the ratio is of demand deposits to reserves

is equal to 0.2, and the ratio of currency to demand deposits is 0.25.
1. What is the money multiplier if we define money as M1?
2. Consider now that ratio of reserves to saving deposits is 0.1 and the ratio of cur-
rency to savings deposits is 0.2. What is the money multiplier if we define money
as M2?
Exercise 1.6
[Proposed] Imagine an economy with types of deposits only: demand deposits (Dv )
and savings deposits (D p ). Suppose the that the ratio is of demand deposits to reserves
is equal to 0.2, and the ratio of currency to demand deposits is 0.25.
1. What is the money multiplier if we define money as M1?
2. Consider now that ratio of reserves to saving deposits is 0.1 and the ratio of cur-
rency to savings deposits is 0.2. What is the money multiplier if we define money
as M2?
Exercise 1.7
[Proposed, Mankiw] To increase tax revenue, the U.S. government in 1932 imposed a 2-
cent tax on checks written on bank account deposits. (In today’s dollars, this tax would
amount to about 34 cents per check.)
1. How do you think the check tax affected the currency-deposit ratio? Explain.
2. Use the model of the money supply under fractional-reserve banking to discuss
how this tax affected the money supply.
3. Many economists believe that a falling in the money supply was in part respon-
sible for the severity of the Great Depression of the 1930s. From this perspective,

was the check tax a good policy to implement in the middle of the Great Depres-
sion?
Exercise 1.8
[Proposed] Suppose an economy with 10 agents and 10 banks, indexed by 1 to 10. Every
bank keeps 50% of deposits in reserves. The central bank gives $10 of currency to agent
1. Agent 1 deposits the money in the bank 1. Then, bank 1 lends half of it agent 2. Agent
2 deposits all its loan at bank 2, that lends half of it to agent 3, that deposits in bank 3,
and so on. When the money finally arrives to agent 10, he decides not to deposit it in
bank 10 and keep the amount to himself.
1. Compute the increase in the money supply in this economy.
2. Now assume that agent i only deposits a fraction 1/i of the funds it gets in the
bank (instead of the full amount). To simplify, also assume that agent 4 decides
not to use the bank (instead of agent 10). What is the increase in the money sup-
ply?

2 Money demand
Exercise 2.1
Consider the simple Baumol-Tobin model where an individual spends uniformly his
annual income Y and makes n withdrawals of equal size to minimize his opportunity
cost (iY/2n) plus the linear cost of withdrawing (Zn), where i > 0 denotes the nominal
interest rate and Z > 0.
1. Write the problem of minimizing the costs and identify the trade-off between the
opportunity cost and the linear cost.
2. What is the most important conclusion of this model and what are its main as-
sumptions? How can you justify the cost of withdrawing?
3. How do you think the demand for money would be affected if the quantity of
banks in which people can make withdrawals increased?
4. Suppose know that people can keep their funds in a savings account (that pays
the interest rate i) and access this funds whenever they need it for transactions us-
ing a debt card (let’s call it electronic money). The money is discounted from the
account only at the moment that the transaction takes place, and thus people do
not incur the opportunity cost i. On the other hand, for every dollar discounted
from the account using the debt card, there is a fee τ ∈ (0, 1) that must be paid.
What happens to the demand for currency in this economy? Under which condi-
tions there is a positive demand for currency in this economy?
5. Suppose the same environment as in the previous item, except that now not all
sellers accept electronic money. Individuals spend a fraction λ of their income on
sellers that accept only currency and a fraction 1 − λ on sellers that accept both

currency and electronic money, where λ ∈ (0, 1). Find the demand for currency
as a function of τ and λ. What happens to the demand for currency when λ → 0?
Exercise 2.2
Answer the questions below according to the Baumol-Tobin presented in class (which
is also presented also Section 15.5.3 of de Gregorio’s book). Are the statements below
true or false? Justify.
1. According to the Baumol-Tobin model, a 10% increase in the interest rate causes
a 5% increase in the demand for money.
2. According to the Baumol-Tobin model, the higher the cost of going to the bank,
the higher the elasticity of the money demand with respect to income.
3. Assume the amount of transactions agents realize in a given year is equal to their
income. Then, the Baumol-Tobin model predicts that high-income individuals
will hold a larger fraction of their income in money assets than low-income indi-
viduals.
Exercise 2.3
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:
u c ( c t , m t ) = β (1 + r t ) u c ( c t +1 , m t +1 ). (2)
1. Show that the household choice satisfies:
it
um (ct , mt ) = βuc (ct+1 , mt+1 ).
1 + π t +1
Interpret this equation.
2. Assume that u(c, m) = ln c − (m − 5)2 . What is the nominal interest rate and infla-
tion 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 in-
tuition for the optimal nominal interest rate. (Tip: remember that money is su-
perneutral in this model.)
Exercise 2.4
[Adapted from Walsh] Consider the basic MIU model in Section 2.2 of Walsh’s book
(also seen in class), with one modification: now the real money balances that the agent
decides to hold at date t yield utility only at date t + 1. More precisely, the instantaneous
utility at date t depends on ct and the real money balances the agent choose at t − 1
(instead of the real money balances he choose at t). Define Mt as the amount of money
the agent choose to hold at date t − 1 (instead of the amount he chooses to held at date
t, as in Section 2.2.). Defining Mt that way, the agent utility can be written as before:

∞ t Mt
∑t=0 β u ct , Pt .
1. Write the budget constraint in nominal terms (i.e., with the interest rate, money

holdings and bond holdings expressed in nominal units).
2. Write the budget constraint in real terms (i.e., with the interest rate, money hold-
ings and bond holdings expressed in real units).
3. Show that in the optimal, the equation below holds for every t:
u m ( c t +1 , m t +1 )
= it .
u c ( c t +1 , m t +1 )
Interpret it.
Exercise 2.5
Consider the basic MIU model in Section 2.2 of Walsh’s book (also seen in class), with
some modifications: now agents can work to increase their production, but working
causes them some disutility. More precisely, the production function is now given by
yt = f (k t−1 , nt ), where nt is the number of hours worked. Normalizing the total num-
ber of hours the worker has available to 1, we have nt = 1 − lt , where lt denotes the
number of hours spent on leisure. The instantaneous utility function of the agent is
given by u(ct , mt , lt ), where the usual assumptions on u(·) and f (·) to guarantee an
interior solution are satisfied.
1. Write the budget constraint in nominal terms (i.e., with the interest rate, money
holdings and bond holdings expressed in nominal units).
2. Write the budget constraint in real terms (i.e., with the interest rate, money hold-
ings and bond holdings expressed in real units).
3. Derive the equations that determine the steady state level of consumption, leisure
and capital. Under which conditions we have superneutrality? Compare the re-
sults obtained here to the ones obtained in the model without labor.

Exercise 2.6
Consider a centralized economy where households produce and consume. The produc-
tion function Y (Kt, nt ) is homogeneous of degree one in both capital and labor. Here,
household incomes are production Yt , monetary transfers from the government Tt and
money balances Mt . On the other hand, the outcomes are consumption ct , investment
in capital It and money balance held for the next period Mt+1 . Capital evolves accord-
ing to the following expression: Kt+1 = Kt (1 − δ) + It .
Now let’s think of a decentralized economy, where households own the resources
capital Kt and labor nt , which is then rented every period by the firms receiving as
payment interest rate Pt rt for capital and wages Pt wt for labor (hence, the real rental
rate of capital is rt and the real wage is wt ). In this economy, there are transfers Tt and
money Mt+1 that households accumulate in t to use in t + 1.
1. Present the budget constraint for both centralized and decentralized economies
in nominal terms.
2. Present the budget constraint for both centralized and decentralized economies
in real terms.
3. Show that we can recover decentralized budget constraint from centralized one
in this setting assuming perfect competition.
Exercise 2.7
[Proposed] Consider the basic MIU model in Section 2.2 of Walsh’s book (also seen
in class) with one modification: assume that there is no capital and the output yt is
exogenously given. Assume that:
u(c, m) = v(c) + ω ln m,

where v(·) satisfies the usual assumptions that guarantee an interior solution.
1. Compute the current price as a function of current and future money supplies.
2. Compute the equilibrium nominal interest rate as function of current and future
money supplies.
Exercise 2.8
[Proposed] Consider an economy with the following state at some date t: β = 0.95,
it = 0.07, πte = 0.02. Expected inflation remains constant while nominal interest rate
increases by 1pp each period. Households preferences are logarithmic on consumption,
having then u(ct ) = ln(ct ) in the CIA model and u(ct, mt ) = ln(ct ) + ln(mt ) in the MIU
model. (The notation is the standard one and the CIA and MIU model referred to are
the ones in Section 2.2 and Section 3.3.1 in Walsh’s book).
1. For each of the models (CIA and MIU) present the household problem, estimate
the first order conditions and find the Euler condition by relating current and
future consumption.
2. How do both results relate? Explain each difference you find.
Exercise 2.9
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:

∞
max
{ct ,k t ,Bt ,Mt }t≥0
∑ βt u (ct )
t =0
s.t. Pt ct + Pt k t + Bt + Mt = Pt f (k t−1 ) + (1 + it−1 ) Bt−1 + Mt−1 + (1 − δ) Pt k t−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→∞
k t , 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; k t is the amount of
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 + Tt is interpreted as a standard cash-in-advance con-
straint, 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
guarantee an unique interior solution (and thus the non-negativity constraints k t , 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). 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 , k t , 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).
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 con-
straint. Write down the Lagrangian using the budget constraints in real units and
derive the first order conditions for ct , k t , bt and mt .
3. In the optimal solution we get the following Euler equation:
u0 (ct )
= β (1 + r t ) h ( i t −1 , i t , ψ )
u 0 ( c t +1 )
where h(it−1 , it , ψ) is a function of it−1 , it and ψ. Derive the functional form of

h ( i t −1 , i t , ψ ).
4. Interpret 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.)
Exercise 2.10
Consider the CIA model in Section 3.3.1 of Walsh’s book (also seen in class) with one
modification: transfers received at date t can not be directly used to purchase goods at
date t, so that the the cash-in-advance constraint takes the form Pt ct ≤ Mt−1 . Assume
that u(c) = ln c. Also, assume that the CIA constraint always binds.
1. Write down the household’s decision problem.
2. Write down the household’s first-order conditions.
3. Derive the Euler equation.

4. Show that:
Mt
= β (1 + i t −1 ) .
Mt − 1
5. Explain what happens to the nominal interest rate in 3 scenarios:
(a) Moneys grows at a constant rate: Mt /Mt−1 = 1 + µ;
(b) Money grows at an increasing rate: Mt /Mt−1 = 1 + µt;
(c) Money grows at a decreasing rate: Mt /Mt−1 = 1 + 1/ (µt).
Exercise 2.11
When we presented the CIA and MIU models in class, we wrote down the centralized
version of it: a single household decided how much to consume, how much capital,
money and bonds to hold. The household had access to a production function that
would transform this capital into consumption goods. Now we set up a decentralized
version of the CIA model.
Consider an economy in which there is a single consumption good that can be used
as capital or for consumption. Time is discrete and indexed by t ∈ {−1, 0, 1, 2, ...}.
There is a representative household and a competitive firm in this economy. Both the
firm and the household are price takers.
Household. The household owns the firm and chooses consumption and how much
capital, bonds and money to hold. At each date t, the household rents the capital it
brought from the previous period (k t−1 ) to the firm at a rental rate Pt × Rt (hence, the
rental rate in units of the consumption good is Rt ). Every period, the household also
receives profits Dt from the firm. Hence, the household problem is:

∞
max
{ct ,k t ,Bt ,Mt }t≥0
∑ βt u (ct )
t =0
s.t. Pt ct + Pt k t + Bt + Mt = Pt Rt k t−1 + (1 + it−1 ) Bt−1 + Mt−1 + (1 − δ) Pt k t−1 + Tt + Dt , ∀t ≥ 0
Pt ct ≤ Mt−1 + Tt , ∀t ≥ 0
B−1 = B > 0, M−1 = M > 0
lim ( Bt /Pt ) = 0,
t→∞
ct , Mt ≥ 0, ∀t ≥ 0.
We are assuming that the profits Dt are only received at the end of the period (and
hence that money is not useful for transactions), while the transfers Tt are received at
the beginning of the period (and hence can be used for transactions). That is why only
Tt shows up in the CIA constraint. The notation is standard and is the same used in
class: u(c) is the instantaneous utility 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 she 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; Tt are cash
transfers received at date t;β ∈ (0, 1) is the discount factor and δ ∈ (0, 1) is the capital
depreciation rate. Define bt ≡ Bt /Pt , mt ≡ Mt /Pt , πt ≡ ( Pt − Pt−1 )/Pt−1 ,τt ≡ Tt /Pt ,
dt ≡ Dt /Pt and let rt denote the real interest rate between dates t and t + 1. Household
solve their problem taking the sequence of prices, interest rates, transfers and profits as
given.
Firm. The firm has access to a production function f (k̃ ). At each date t, the firm
chooses how much capital k̃ t to rent from the household. Hence, at each date t the firm
problem is:
max Πt ≡ Pt f (k̃ t ) − Pt Rt k̃ t
k̃ t
subject to k̃ t ≥ 0.

Market clearing. The following market clearing must hold:
Bt = 0, ∀t ≥ 0
k̃ t = k t−1 , ∀t ≥ 0
c t + k t = f ( k t −1 ), ∀t ≥ 0
Moreover, Tt = Mt − Mt−1 , since the government can only make transfers by issuing
more money.
Assume that u(·) and f (·) satisfy all the usual assumptions that guarantee an unique
interior solution (and thus the non-negativity constraints 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). There is
no uncertainty and the household takes as given the path of prices, interest rates and
all exogenous variables.
1. Write down the household problem in real units.
2. Derive the first order conditions of the household problem.
3. Write the first order condition of the firm.
4. Show that in equilibrium Rt = f 0 (k t−1 ) and rt = Rt+1 − δ .
5. Show that the steady state in the decentralized model is the same as in the cen-
tralized model (that is, the model of section 3.3.1 in Walsh’s book, which is the
one seen in class).
Exercise 2.12
[Proposed] Suppose the representative household chooses consumption of cash goods

({ct }t≥0 ), consumption of credit goods ({dt }t≥0 ), nominal bond holdings ({ Bt }t≥0 ) and
hours of work ({nt }t≥0 ) to maximize
∞
∑ βt [u(ct , dt ) − γnt ]
t =0
subject to the nominal budget constraint
Pt (ct + dt ) + Mt + Bt = Wt nt + (1 + it−1 ) Bt−1 + Tt + Mt−1
and a cash-in-advance constraint of the form
Pt ct ≤ Mt−1 + Tt .
Where γ > 0, nominal wages are denoted by Wt and the remaining notation is the
standard one. Denote the real wage by wt and real bond holdings by bt . The usual
non-negativity constraint on c and l must hold, as well as the solvency constraint
(limt→∞ bt = 0). Moreover, bonds and money at the beginning of period zero are given.
Assume that:
u(ct , dt ) = α ln ct + (1 − α) ln dt , with α ∈ (0, 1).
1. Write the cash-in-advance constraint and budget constraint in real units.
2. Derive the first order conditions with respect to ct , nt , dt and bt .
3. Compute the steady state (assuming a constant inflation rate, real wage, con-
sumption, hours of work, bond and money holdings). Does this model exhibit
superneutrality? Explain.
4. Maximizing utility at the steady state, what is the optimal inflation in this econ-
omy?

5. Write down an expression for the share of cash in total consumption as a function
of the nominal interest rate. How does the share of cash goods consumed depend
on the interest rate?
Exercise 2.13
[Proposed] Consider the CIA model in Section 3.3.1 of Walsh’s book (also seen in class)
with one modification: to accumulate capital agents need to have cash in advance. In
other words, the CIA constraint now is given by:
Pt ct + Pt (k t − (1 − δ) k t−1 ) ≤ Mt−1 + Tt
That is, now not only consumption must be purchased with cash, but also capital goods.
1. Present the Lagrangian of this problem, denoting by λt and µt the multipliers for
the budget constraint and the CIA constraint. Derive the first order conditions.
2. Show that:

0 0 1
u (ct ) = βu (ct+1 ) f 0 (k t ) + βu0 (ct+1 )(1 − δ)
1 + i t +1
3. Assuming a production function f (k ) = kα , with α ∈ (0, 1) solve for the stationary

state capital kss . Is money superneutral in this version of the model? Give some
intuition on your result.
4. Now consider the same economy but with the usual CIA constraint Pt ct ≤ Mt−1 +
Tt . The steady state capital in that economy, with f (k t ) = kαt , is given by:
! 1
1− α
α
kss = 1
β −1+δ

Find the inflation rate that equates steady state capital in both economies and then
explain how this relates to Friedman rule.

3 Monetary equilibrium
Exercise 3.1
[Mankiw] In the country of Wiknam, the velocity of money is constant. Real GDP grows
by 3 percent per year, the money stock grows by 8 percent per year, and the nominal
interest rate is 9 percent. What is the growth rate of nominal GDP, the inflation rate and
the real interest rate?
Exercise 3.2
[Mankiw] Suppose a country has a money demand function Md /P = κy, where κ is a

constant parameter and y is real income. The money supply grows by 12 percent per
year, and real income grows by 4 percent per year.
1. What is the average inflation rate?
2. How would inflation be different if real income growth were higher? Explain.
3. How do you interpret the parameter κ? What is its relationship to the velocity of
money?
4. Suppose, instead of a constant money demand function, the velocity of money in

this economy was growing steadily because of financial innovation. How would
that affect the inflation rate? Explain.

Exercise 3.3
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:
m t − p t = − η ( p t +1 − p t ) (1)
where η 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 η
pt =
1+η ∑ 1+η
mt+i = m̃
i =0
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).
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...”)
Exercise 3.4
[Proposed] 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:
m t − p t = − η ( p t +1 − p t ) (1)
where η is a constant larger than zero. You may assume that mt is bounded.

1. Write pt as a function of the current and future money supply. Interpret the re-
sults.
2. Are there solutions to (1) that depend on variables other than the money supply
and the parameter η (i.e., non-fundamental solutions, bubbles)? If your answer is
yes, provide one example and show that it satisfies (1). If your answer is no, show
that there is no bubbles.
3. Suppose the money supply is constant and equal to m̃ and everyone is certain it
will remain at that level forever. Using your solution in item 1, characterize the
price level.
4. Suppose now that at date 0 the centrak bank announces that the money supply
will be equal to m̃ from date 0 to date T − 1, and that at date T the money supply
will increase to m̃0 > m̃ (and remain at the new level forever). In a graph and using
the fundamental solution, show the evolution of the price level as a function of
time. Intepret the results.

4 Seignioriage
Exercise 4.1
Consider an economy with a single final good. The seigniorage revenue in real terms
in a given period is given by
∆M
S= ,
P
where ∆M is the increase in the money supply and P is the price of the good. The
demand for money is given by M/P = Ye−αi , where i is the nominal interest rate, Y is
output and α > 0. Using the Fisher equation (and assuming expected inflation is equal
to actual inflation), we can write M/P = Ye−α(r+π ) , where r is the real interest rate and
π is the inflation rate. Suppose that in the long run the interest rate and output are
constant (i.e., ∆i = 0 and ∆Y = 0). Find the inflation rate that maximizes S in the long
run.
Exercise 4.2
Consider the following money demand:
Md
= y [1 − (r + π e )]
P
where y is the real output, r is the real interest rate and π e is expected inflation.
1. Derive an expression for the seigniorage revenue assuming y = 250, r = 0.05

and π e = 0.1 (and all those are independent of money growth). Compute the
seigniorage revenue for the following growth rates of the money supply: 25%,
50% and 75%. What is the relationship between seigniorage and money growth?
2. Assume now that expected inflation is equal to actual inflation (π = π e ), while the

other variables are the same. Compute the seigniorage revenue for the following
growth rates of the money supply: 25%, 50% and 75%. Why are your answers
different from the previous item? Explain.
3. Assuming π = π e , find the rate of monetary expansion that maximizes the seignior-
age revenue.
Exercise 4.3
[Adapted from de Gregorio] Suppose an economy in which agents keep money as cur-
rency and as deposits. The money multiplier is denoted by µ̃. The demand for real
balances in this economy is given by:
L(i, y) = ay (b − i ) ,
where y is real output.
1. Compute the seigniorage if the inflation rate is 10%. What assumptions do you
need to make to be able to compute the seigniorage?
2. Suppose b > r, where r is the real interest rate. Compute the inflation rate that
maximizes the government revenue. What happens with the inflation rate that
you found if the real interest rate increases?
3. Suppose now that in reality the multiplier increases. How does this change your
answer in item 1?

Exercise 4.4
[Adapted from de Gregorio] The money demand is given by:
M
= α − βi + γy.
P
The notation is the usual one.
1. Find the seigniorage (S), assuming π = π e , and discuss how π relates to S. In

order for a revenue maximizing seigniorage to exist, do we need some restriction
on parameters?
2. If it exists, compute the inflation rate that maximizes seigniorage.
Suppose now that in this economies output grows at a rate g.
3. Write the seigniorage as a function of the parameters α, β, γ, the real output y, the
growth rate g, the inflation rate π and the nominal interest rate i. Use the Fisher
equation.
4. Find the inflation rate that maximizes seigniorage. Hows does it compare to item
2?
Exercise 4.5
[Proposed, adapted from de Gregorio] Consider the following money demand func-
tion:
Mt e
= mt = yt e−απt , (1)
Pt
where M is the nominal quantity money, P is the price level, m is the real quantity of
money, y is real output (which is normalized to 1 hereafter), π e is expected inflation
and α is a positive constant.

Suppose the government wishes to finance a real deficit d by increasing the nominal
money supply at a rate of σ. The seigniorage is Ṁt /Pt (you can omit the subscript t).
1. Write the government budget constraint as a function of σ and π e and plot on the
planer (π e , σ). Using equation (1) (take derivatives), determine the steady state
and find the maximum value of d that you can finance in steady state through
seigniorage (denote it by d M ). Suppose d < d M . How many steady states there
is? Show your results in the graph.
2. Suppose expectations are adaptive:
π e = β (π − π e ) . (2)
Explain that equation. Differentiate equation (1) and using (2) to replace replace
the inflation rate, show what is the dynamic of expected inflation in the graph,
and find two steady states. Show which steady state is stable and which one is
unstable (assume that βα < 1).
3. Suppose there is an increase in the deficit from d to d0 , both being smaller than d M .
Show the dynamics of the adjustment (remember that σ can jump, but π e adjusts
slowly). Finally, suppose that d increases some d00 above d M and show that we get
an hyperinflation.

5 Exchange rates
Exercise 5.1
[Adapted from de Gregorio] Suppose an economy with three countries, A, B and C.

The value of imports in countries A and B are given by
q A M A = 250 − 2q A + 0.4Y A
q B M B = 260 − 2q B + 0.4Y B
where Y j denote output in country j and q j is the real exchange rate between country j
and country C. Exports in each country are given by
X A = 1200 + 3q A
X B = 100 + 2q B
I am implicitly assuming that A and B only export to and import from country C, not
between each other (that is why they only care about the real exchange related to coun-
try C). Assume that Y A = 3000 and Y B = 300 are exogenously given. Investment in
each country is given by
I A = 1000 − 2r A
I B = 150 − r B

Domestic savings in each country is given by
A
SD = 350 + r A + 0.2Y A
B
SD = 10 + r B + 0.2Y B
where r j denotes the real interest rate in each country.
1. Suppose these countries (A, B and C) live in financial autarky (they do not borrow
to or lend from the rest of the world). Find the equilibrium real exchange rate and
real interest rate in country A and B.
2. Suppose the barriers that do not allow country A and B to borrow or lend between
each other are removed (but country C is still in financial autarky). Compute the
equilibrium real exchange rates in each country.
3. Suppose now that there was also in change in tariffs after the financial openness,
so that the value of imports in country B fell 16 units (the function that determined
q B M B changed, changing the equilibrium M B ). What will happen with q B ?
Exercise 5.2
1+rt∗ e
1. Show that qt = 1+r t q t +1 (the notation is the standard one).
2. Express the Marshall-Lerner condition in terms of elasticities. You may assume

that the country has a zero trade deficit (X = qM).
Exercise 5.3
[Proposed] Suppose that at date t you can buy or sell USD in future markets at a price
f t+1 . In other words, agents agree at t that they will buy/sell dollars at t + 1 at the
agreed price f t+1 .

f t +1
1. Suppose all agents in the economy are risk neutral. Show that 1 + it = (1 + i∗ ) et .
2. Do you expect that equation to hold in practice?
Exercise 5.4
[Proposed] Suppose inflation in the US is always 3%, while inflation in Chile is always
2%. Suppose also that the nominal exchange rate between CLP and USD is fixed. What
do you expect to happen to the nominal interest rate in Chile?
Exercise 5.5
[Proposed] Explain (using a graph) what you expect to happen to the real exchange
rate in each of the scenarios below.
1. The government increases expenditure without increasing taxes. Assume the in-
crease in government purchases only increase demand for domestic goods.
2. The government reduces import tariffs. Suppose first it does not affect other taxes
and then that the government compensates the reduction by increasing other
taxes.
3. The productivity increases because the government found a lot of oil.

6 Goods and money markets
Exercise 6.1
Consider the basic model of equilibrium in the goods market, which has the following
assumptions: (i) all firms produce the same good that can be used for consumption,
investment or by the government; (ii) the economy is closed; (iii) firms are willing to
supply any amount of the good at a given price level.
Consumption (C) is given by
C = c 0 + c 1 (Y − T ) ,
where Y denotes the income, T denotes taxes (minus government transfers) and c0 > 0
and c1 ∈ (0, 1) are parameters. Investment is exogenous and fixed at some level I and
the same applies to government spending, denoted by G.
1. What is the equilibrium level of output Y?
2. Only on this item, suppose that there is some regulation that forces the govern-
ment to run a balanced budget. That is, G must always be equal to T. Therefore,
any increase in government spending must be compensated by an equal increase
in taxes. Can the government still affect the level of output using fiscal policy (i.e.,
changing G and T, but keeping the budget balanced)? Explain.
3. Now suppose that T depends on Y, according to
T = t0 + t1 Y, with t0 ≥ 0, and t1 ∈ (0, 1).
Compute the equilibrium level of output Y. Compare the government spending

multiplier you got in Item 1 with the one you got here. Which multiplier is larger?

Exercise 6.2
Suppose that when the nominal interest rate i is larger than zero the money demand
(Md ) is given by
Md = $Y (0.25 − i ),
where the nominal income $Y is $100. When i = 0, agents will demand at least 0.25 ×
$Y units of money, but are indifferent between holding any amount of money equal or
larger than 0.25 × $Y. Suppose the supply of money is $20.
1. What is the equilibrium interest rate?
2. What is the equilibrium interest rate when the money supply is $30?
3. What happens to the equilibrium nominal interest rate when the central bank
increases the money supply from $30 to $40?
4. Suppose the money supply is $25 and the nominal income $Y increases from $100
to $200. Will the equilibrium nominal interest rate increase? Show what happens
using a demand and supply graph.
Exercise 6.3
Consider the model of Chapter 3 in Blanchard, where investment and government are
fixed at I and G, respectively, and consumption is given by
C = c 0 + c 1 (Y − T )
where Y denotes real output and T are taxes, and c0 > 0 and c1 ∈ (0, 1). Answer true
or false to the statements below, justifying your answers.

1. An increase of 500 units in government expenditure has the same effect on equi-
librium output as a decrease of 500 units in taxes.
2. An increase of 10% in G always leads to an increase of 1/(1 − c1 )% in output.
3. The higher the marginal propensity to consume, the higher the increase in GDP
after a marginal decrease in taxes.
4. Suppose taxes are a fraction of total income, i.e., T = τY. The government spend-
ing multiplier is larger than when T is fixed.
5. Suppose the government runs a balanced budget always, i.e.,T = G. An increase

of one unit in G causes an increase of one unit in output.
6. Suppose there are two group of people in a country (of equal size and each earns
half of the total income). One group has a marginal propensity to consume higher
than others. A policy that taxes the group with the low propensity to consume
and transfer the amount to the group with the high propensity to consume will
increase output.
Exercise 6.4
[Proposed] Answer the questions below.
1. Consider a bond that promises to pay $100 in one year. What it is the interest rate
on the bond if its price today is $80, $95 and $110?
2. Suppose there are no costs associated with storing currency. Explain why the
nominal interest rate cannot go below zero.

7 IS-LM
Exercise 7.1
Consider the basic IS-LM model where the central bank fixes the money supply. Sup-
pose country A is at the liquidity trap, as described in the graph below.
Interest
rate, i
LM
Equilibrium
0
IS
Output, Y
Now consider the following idea:
“Imagine that the Fed were to announce that, a year from today, it would pick a digit from
zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer
be legal tender. Suddenly, the expected return to holding currency would become negative 10
percent.
That move would free the Fed to cut interest rates below zero. People would be delighted
to lend money at negative 3 percent, since losing 3 percent is better than losing 10.” Gregory
Mankiw, NY Times, April 18, 2009
(http://www.nytimes.com/2009/04/19/business/economy/19view.html)
Assume that country A initially has notes with 10 different colors and the total value
of the currency of a given color is the same across colors. Based on the idea above, the

central bank implements the following policy. Every year the central bank chooses
randomly one color (with equal probability for each) and all notes with that color lose
its value. Every time the central bank picks the currency color that will have its legal
tender status withdrawn, it immediately puts the same amount of money back in the
economy in notes created with a color not yet used (think that money is thrown from a
helicopter). Thus, the money supply is fixed. People in that country only use currency
to make transactions.
1. How would that policy affect the equilibrium output in this economy? You can
use your intuition to answer it, or you can base it on your answer to item 3 below.
2. Draw the money demand curve of this economy before and after the policy.
3. In the same graph, draw the IS and LM curves before and after the policy. (Obs:
the IS and LM curves before the policy are already drawn in the graph above, but
draw it again to compare with the new equilibrium).
Exercise 7.2
In a graph, represents what happens in the IS-LM after each of the shocks below. Ex-
plain how the transition between the old equilibrium and the new equilibrium occurs,
plotting in a graph the path of the nominal interest rate i and output Y. To derive the
transitions, assume that money markets are always in equilibrium, while goods mar-
kets can be not in equilibrium during the transition. Assume that the bank central fixes
the money supply (assumption A1 in class).
1. A permanent increase in G.
2. A permanent increase in M.

Exercise 7.3
Answer the questions below considering the following modifications of the standard
IS-LM model seen in class in which t the central bank fixes the money supply (assump-
tion A1).
1. Derive the IS curve assuming that the investment does not depend on the interest
rate. What is the impact of monetary and fiscal policy in this case?
2. Derive the LM curve assuming that the money demand does not depend on the
interest rate. What is the impact of monetary and fiscal policy in this case?
3. Derive the LM curve assuming that the demand for real balances does not depend
on income. What is the impact of monetary and fiscal policy in this case?
4. Suppose Md /P = aY, where a > 0. Derive the LM curve when a → ∞.
Exercise 7.4
Answer the questions below using the IS-LM model for a closed economy in which the
central bank fixes the money supply.
1. Suppose a country wants to reduce its fiscal deficit, but at the same time, it does
not want to reduce output. Suggest a policy (or a mix of policies) that could
achieve those objectives. Explain it using the IS-LM diagram.
2. Suppose now that a government decides to increase spending (G), but to keep the
fiscal deficit constant it also increases a lump-sum tax (T) in the same amount.
Using the IS-LM diagram, explain the effect of these policies.
3. Suppose the central bank increases the money supply in a permanent way at some
date τ. Represent the new equilibrium in the IS-LM diagram, as well as the transi-
tion for the new equilibrium. To show the transition, plot output and the nominal

interest rate as a function of time. When analyzing the transition, assume that
money markets are always in equilibrium, while goods markets adjust slow.
Exercise 7.5
Consider a closed economy in which the central bank fixes the money supply. Short
term activity is characterized by the following equations:
C = c 0 + c 1 (Y − T )
I = I0 − I1 r + I2 Y
G = Ḡ
T = τY
Ms M̄
=
P P
M d
= l0 − l1 i
P
where C represents the aggregate consumption function, Y denotes income, I aggregate

investment, G is total public expenditure, T represents the level of taxes (note that we
Ms
are assuming taxes are proportional to income and not lump-sum as usual), P and
Md
P denote money supply and demand in real terms, and P represents the price level.
Finally c0 , I0 , I1 , I2 , Ḡ, M̄, l0 are positive, and τ, c1 ∈ (0, 1).
1. Define the IS curve. Determine its functional form at this economy.
2. Obtain the government spending multiplier and explain intuitively it represents.
3. Define the LM curve and determine its functional form.

4. Find an expression for the equilibrium output and nominal interest rate in this
economy, indicating step by step how you did obtain it.
5. Using derivatives, quantify the total effect on income of an increase in money

supply. Give the intuition of your results.
6. Why do we generally use without distinction i or r in this model?
Exercise 7.6
Consider an economy in which the central bank fixes the money supply described in
the following set of equations.
C = 1 + 0. + 0.8(1 − t)Y
I = 2 − 0.4i
G=1
t = 0.2
Ms = 6
Md = 0.75Y − 1.5i
The notation is the standard one. Note that income taxes are proportional to income,
instead of lump sum.
1. Provide Y and i values in equilibrium.
2. Assume that autonomous investment decreases by 10%. What level of govern-

ment spending restores previous income level?

3. Assume now that private investment is taxed proportionally to the investment
rate. In particular, assume that:
I = 2 − 0.4(1 + τ )i (1)
where τ = 0.25. Compute new equilibrium. Compare your results with those at
item 1.
4. Assuming the new investment function, what level of money supply restores in-
come to the level of item 1? Explain your results.
Exercise 7.7
[De Gregorio] Consider a closed economy in which the central bank fixes the money
supply characterized by the equations below:
Y = C+I+G
C = C̄ + c1 (Y − T )
I = Ī − αr
Md = kY − θi
i = r + πe
where Y represent income, C consumption, I denotes investment, G denotes govern-

ment expenditure, T represents taxes, i is nominal interest rate, r is real interest rate, π e
denotes expected inflation and Md is the real money demand (note that this implicitly
assumes a price level of 1). Finally c1 , α, Ī, k, θ are positive parameters. Denote the

money supply my Ms .
1. Assume initially that expected inflation equals π0 . Obtain equilibrium equations

in money and goods markets. Graph each of them in the plane (r, Y ).
2. Obtain expressions for equilibrium income Y, and real and nominal interest rates.
3. A change in economic expectations triggers a drop of expected inflation to π1 <

π0 . Analyze how this change affects the economy.
4. What monetary policy should be implemented to stabilize income?
5. Assuming C = 5, I = 1, T = 2, G = 2, Ms = 3, c = 0.8, α = 0.8, k = 0.25, θ =

0.75, π0 = 3, π1 = −5, obtain equilibrium variables before and after expectations
adjust.
6. Given numerical results in the previous answer, which constraint restricts the cen-
tral bank when stabilizing income? How can the fiscal authority help to overcome
it?
Exercise 7.8
[Proposed] The government of a country, after years running large fiscal deficits, is
forced to reduce its deficit in a given year. Increasing taxes takes a lot of time and it is
not an available option in the short run. Using the IS-LM model where the central bank
fixes the nominal interest rate, explain how this country could avoid a fall in output in
the short run.
Exercise 7.9
[Proposed] Take two countries that are identical except for the behavior of the central
bank: in country A the central bank fixes the nominal interest rate (and adjusts the

money supply to achieve it), while in country B the central bank fixes the money sup-
ply. Initially, both countries are at an equilibrium in which the interest rate and output
are the same. Suppose both countries experience the same reduction in goverment
spending. Which country will suffer a larger output loss? Explain your answer using
the IS-LM model.

8 Mundell-Fleming
Exercise 8.1
Consider an open economy characterized by the following equations:
C = c 0 + c 1 (Y − T )
I = d0 + d1 Y
I M = m1 Y
X = x1 Y ∗
where, C denotes consumption, Y denotes the domestic income, I denotes investment,

I M and X are the quantity of imports and exports, respectively. The parameters m1
and x1 are the propensities to import and export. Assume that the real exchange rate
is fixed at a value of 1 and treat foreign income, Y ∗ , as fixed. Also assume that taxes,
T, are fixed and that government purchases, G, are exogenous (i.e., decided by the
government). Note that differently from the standard Mundell-Fleming model seen in
class, here we assume that investment does not depend on the interest rate.
1. Write the equilibrium condition in the market for domestic goods and solve for
Y.
2. What is the government spending multiplier? (Assume that 0 < m1 < c1 + d1 <
1)
3. What is the change in net exports when government purchases increase by one
unit?
4. Suppose the government decides to close the economy, not allowing trade with

the rest of the world (i.e., I M = X = 0). Find the government spending multiplier.
Is it larger or smaller than the multiplier you found in item 2? Explain, in words,
why the two multipliers are different.
Exercise 8.2
Suppose a country operates under a fixed exchange rate regime and has perfect capital
mobility. At date t, the central bank spends 100 units of local currency buying domestic
bonds in an open market operation. Suppose that between dates t + 1 and t financial
investors had time to fully react to the open market operation.
1. Is the monetary base at t + 1 larger, equal or smaller than the monetary base at
date t?
2. Did the central bank balance sheet change between dates t + 1 and t? If yes, how
did it change?
Exercise 8.3
To answer the questions below use the Mundell-Fleming model of an open economy.
1. Suppose a country has perfect capital mobility and operates under a flexible ex-
change rate regime. Suppose the country is in a severe recession, and policymak-
ers are looking for a policy (or a mix of policies) to increase output. Moreover, they
would like to ensure net exports will not be affected by those policies. Changing
the exchange regime from flexible to fixed is not a posssibility. How could this
country increase output without affecting net exports? Explain using graphs and
words.
2. Suppose now a country that has perfect capital mobility and operates under a
fixed exchange rate regime. Suppose there is a sudden exogenous increase in

the demand for exports (say that the income in the rest of the world increased).
What will be the effect of this higher demand for exports on the amount of foreign
currency reserves of the central bank? Explain using graphs and words.
Exercise 8.4
[Proposed] Answer the following questions according to the Mundell-Fleming model

with perfect capital mobility and flexible exchange rates seen in class (de Gregorio,
chapter 20).
1. How does an increase in government spending affects output, interest rates and
the exchange rate? Explain using graphs and words.
2. How does an increase in the money supply affects output, interest rates and the
exchange rate? Explain using graphs and words.
3. How does an increase in the international interest rate affects output interest rates
and the exchange rate? Explain using graphs and words.
4. Answer items 1, 2 and 3 again assuming a fixed exchange rate regime instead of
flexible exchange rate regime.
5. Still assuming a fixed exchange rate regime and perfect capital mobility, what
happens when the central bank increases the fixed exchange rate? Explain using
graphs and words.

9 Phillips curve
Exercise 9.1
Consider the following modified version of the Lucas model. There is a continuum [0, 1]
of firms indexed i. Pi denotes the price level of firm i and yis is the quantity produced
R1
by firm i. Total output is y = 0 yis di.
The price level P is drawn from a normal distribution with mean µ P and variance
1/τP . The price of each firm is Pi = P + ri , where ri denotes the relative price of each
firm. ri is drawn from a normal distribution with zero mean and a variance 1/τr (iid
across firms).
Each firm observes two informations before deciding how much to produce: (i) its
own price Pi ; (ii) a noisy signal wi = ri + ζ i , where ζ i ∼ N (0, 1/τw ) (iid across firms).
The parameter τw is called the precision of the signal wi and it represents how good is
the information received by firm i about its relative price. If τζ → ∞, firms learn almost
perfectly about its relative price. This signal is meant to capture information about their
relative prices firms gather from various sources.
Once firms have set their expectation of ri conditional on Pi and wi (denoted by
E [ri |wi , Pi ]) they produce according to
yis = y + γE [ri |wi , Pi ]
Tip: If an agent has prior N (y, 1/τy ) and receives two signals x A = z + η A and x B =
z + η B , with η A ∼ N (0, 1/τA ) and η B ∼ N (0, 1/τB ) about some random variable z,
τ x A +τ x B +τ y
then E z| x A , x B = A τA +τBB +τy y . The τ’s are called precisions (it is the inverse of the

variance).
1. Compute E [ri |wi , Pi ].

2. Write total output as function of P and E [ P] (which is the parameter µ P ).
3. What happens to your answer of the previous item when τw → ∞? Interpret it.
Exercise 9.2
In class we have seen three different types of frictions that can generate a positive re-
lationship between output and inflation: (i) wage rigidities; (ii) price rigidities (Calvo’s
model); and (iii) information rigidities (Lucas’ model). Briefly explain in words how
they can generate a positive relationship between output and inflation (the Phillips
curve). You do not need to solve the models, you should only clearly explain in words
the economic intuition behind it.
Exercise 9.3
[Proposed] Suppose an economy with three different types of firms.

The first type has flexible prices (they can adjust it freely in each date) and they fix
it according to:
p f t − pt = κ (yt − y) , κ>0
where p f t denotes the price set by firms with flexible prices; pt is the price level; yt is
output and y is potential output. All variables are expressed in logarithms.
The second type of firms has fixed prices, and they fix their price prt according to
their expectations of the price level and output:
prt − pet = σ (yet − y) , σ>0
Let’s assume that expected output is always equal to potential output: yet = y for every
t. Let αr denote the fraction of firms with fixed prices

The third type of firms fix their prices at date t according to the past price level pt−1 ,
readjusting the price by the inflation rate (indexation). In particular those firms set their
price pit according to:
pit = pt−1 + πt−1
The proportion of those firms is αi . Hence, there is a proportion 1 − αr − αi of firms

with flexible prices. Since all variables are expressed in logarithms, you can use the
approximations: pt − pt−1 = πt and pt − pet = pt − pt−1 − ( pet − pt−1 ) = πt − πte ,
where the superscripts e denote expectations and πt is the inflation rate.
1. Show that:
1
yt = y + [α (πt − πt−1 ) + αr (πt − πte )]
λ i
where λ = (1 − αr − αi ) κ.
2. Interpret the equation you found in the previous item. Compare it with the situ-
ation in which there are no firms that index their prices (αi = 0).

10 IS-LM-PC
Exercise 10.1
Consider the IS-LM-PC model and suppose there is an increase the price oil. Intepret
this increase in the price of oil as a change in potential output. Assume that before the
shock output is equal to potential output. Compare the response of the economy in two
cases: (i) expected inflation always equal lagged inflation; (ii) inflation expectations are
anchored at some level π. In the medium run, the central bank adjusts interest rates
to keep it as close as possible to potential output. You may assume that initially the
interest rates are very high, so that the zero lower bound will not be binding. Write
a graph with time on the horizontal axis and the path of output and inflation on the
vertical axis, for each of the cases mentioned.
Exercise 10.2
Consider the IS-LM model where the central bank fixes the real interest rate. Assume
that inflation expectations are anchored at some level π. Suppose the government de-
cides to reduce government spending in a permanent way. Also, assume interest rates
are sufficiently high, so that the central will not be constrained by the zero lower bound
(therefore, you can simply ignore the zero lower bound).
1. What is the effect on output of this change in the short run? Explain your answer
using the IS-LM model.
2. What is the effect on output of this change in the medium run, assuming the
central bank will try to make inflation equal to π? Explain your answer using the
IS-LM-PC model.

3. In the medium run, the IS-LM-PC model predicts that investment will increase or
decrease? Justify.
Exercise 10.3
You should provide your answer to this question using the IS-LM-PC model seen in
class. Suppose that at the initial date, an economy has inflation, expected inflation
and real interest equal to 0. The natural real interest rate of this economy (i.e., the real
interest rate that would make output equal to potential output) is negative. Expected
inflation is always equal to the inflation of the previous period (i.e., πte = πt−1 ). The
central bank always tries to bring output as close as possible to potential output, but
nominal interest rates cannot go below zero.
1. According to the IS-LM-PC model, after the intial date the real interest rate will
increase, decrease or remain stable? And output will increase, decrease or remain
stable? Explain (drawing a graph may be very useful for that).
2. Explain, using the IS-LM-PC model: can fiscal policy make output equal to po-
tential output? How?
Exercise 10.4
Brazil’s policy real interest rate are very high. Many economists argue that part of that
is caused by the fact that there is a development bank in Brazil (called BNDES) lending
at interest rates way below the the market interest rate (for some selected firms). They
argue that it makes monetary policy less powerful, forcing the central bank to increase
the interest rate a lot to reduce inflation. The following simple extension of the IS-LM-
PC model is proposed to check if that intuition survives a more formal treatment and
to try to understand better the mechanisms behind this kind of argument.

Suppose that a fraction 1 − λ of firms in the economy borrow at the policy rate plus
the risk premium (r + x), and a fraction λ borrows at (1 − s) (r + x ) from the BNDES,
where s denotes the BNDES subsidy. Each firm has a linear investment function on Y
and on the interest rate they borrow, so that the aggregate investment is equal to:
I = b0 + (1 − λ) [b1 Y − b2 (r + x )] + λ [b1 Y − b2 (1 − s)(r + x )]
The consumption function is standard: C = c0 + c1 (Y − T ), with the usual assumption

that b1 + c1 < 1. Also, inflation expectations are anchored at π.
1. Suppose that initially λ = 0 (no BNDES) and output is equal to potential. At date
t λ becomes positive (the development bank is introduced). How will that affect
the equilibrium in the short and medium run?
2. Now suppose that the government decides to increase λ but at the same time
increase taxes, so that the short run equilibrium remains the same. What happens
in the medium run?
3. Now consider the case with λ = 0 and the case where the government increases λ
and increases taxes as in item 2. Suppose there is an increase in c0 and compare the
medium run equilibrium in both cases. Does it make sense to say that monetary
policy became less powerful because of the subsidized credit?
Exercise 10.5
Consider a country that has had a very low level of investment for decades. Some
economists argue that that investment is low because government spending is very
high. Suppose that the government of this country decides to reduce government
spending (G) in a permanent way.

Using the IS-LM-PC model, answer the questions below. Assume that inflation ex-
pectations are anchored at some level π. Also, assume that interest rates are sufficiently
high, so that the central bank will not be constrained by the zero lower bound (there-
fore, unless otherwise stated, you can simply ignore the zero lower bound). As usual
in the IS-LM-PC model, you must assume that the central bank will not react to shocks
in the short run, but will adjust real interest rates in order to bring output as close as
possible to potential output in the medium run. Also, assume that before the change in
government spending, the economy was in an equilibrium with output equal to poten-
tial output.
1. What is the effect on output of the reduction in government spending ( G) in the

short and medium run? Explain your answer using the IS-LM-PC diagram.
2. In the short run, is investment larger or smaller after the reduction in G? In the
medium run is investment larger or smaller after the reduction in G? In your
answer, you must assume that investment is an increasing function of output and
a decreasing function of the real interest rate (as usual).
Now we replace some assumptions. First, instead of assuming anchored expectations,

we assume adaptative expectations. Second, we assume that at the initial date infla-
tion, expected inflation, nominal and real interest rates are all equal to zero (using the
notation used in class i = π = π e = r = 0 at the initial date). Hence, you can no longer
ignore the zero lower bound. The economy still has output equal to potential output at
the initial date. Answer the question below.
3. After a permanent decrease in government spending, what will happen to the

real interest rate in the medium run? Explain using the IS-LM-PC diagram.

11 AS-AD
Exercise 11.1
Consider the basic 3 equation aggregate demand and aggregate supply model (the no-
tation is the same used in class):

π = π e + θ (y − y) + ε




 (OA)


 y − y = A − φ (i − π ) + µ (IS)




i = r + π + a ( π − π ) + b ( y − y )
 (Taylor rule)
where r = A/φ and the same condition on parameters and shocks assumed in class is
satisfied.
1. Derive the RPM curve seen in class and represent the equilibrium in a OA-RPM
diagram.
2. Suppose the economy is initially at its long run equilibrium π = π = π e , y = y,

r = r = A/φ and i = i = r + π. Represent and discuss in a OA-RPM diagram the
effect of a temporary and positive inflationary shock ε > 0.
3. Can the OA-RPM diagram say something about what happens with the interest
rate after a inflationary shock?
4. Write the output gap y − y and π − π as a function of parameters and the exoge-
nous shocks ε and µ. Find a condition on the parameter b that implies an increase
in interest rates after positive inflationary shock.
5. Suppose the central bank wants to minimize the variation of the output gap. As-
sume the constant a > 1 is fixed, but the central bank can adjust b to achieve

his goal. What should the central bank do? You can assume that π e is constant.
Remember that the shocks ε and µ are assumed to be independent and iid.
Exercise 11.2
[Proposed, adapted from de Gregorio] Consider the basic aggregate demand and ag-
gregate supply model (the notation is the same used in class):

π = π e + θ (y − y) + ε

 (OA)

 y − y = A − φ (i − π ) + µ
 (IS)
1. Suppose the central bank follows a rule to keep the nominal interest rate always
constant at some level î. What is the implicit inflation target (π)? Suppose infla-
tion expectations are always equal to the inflation target. Plot the Phillips curve
and the monetary policy rule on the (y, π ) space. Find the equilibrium output
and inflation as a function of paramters and shocks.
2. Suppose now the central bank follows an usual Taylor rule, with a > 1 and b > 0.
Is the variance of inflation higher or lower than in item 1? Remember that the
shocks ε and µ are assumed to be independent and iid.

12 Dynamic inconsistency
Exercise 12.1
Suppose the loss function of the central bank is given by
L = π 2 + γ ( u − u n + κ )2 .
The Phillips curve is given by u = un − η (π − π e ). The parameters γ,η and κ are both
strictly larger than zero.
1. Compute the equilibrium inflation under discretion.
2. Compute the equilibrium inflation under full commitment.
3. Is the central bank loss larger under discretion or under full commitment? Justify
doing the algebra.
Exercise 12.2
Time starts at date 0. The loss function of the central bank at date t is given by
Vt = πt2 + λ (yt − y − κ )2
and the Philips curve is as usual: yt = y + θ (πt − πte ). At each date τ, the central bank
minimizes the discounted sum of Vt :
∞
Wτ = ∑ βt−τ Vt
t=τ
where β ∈ (0, 1) and λ, θ > 0. We know that under discretion in an one period model,
the central bank would choose π = π q = λθκ, and we also know that under full

commitment the inflation would be zero. Now suppose people forms their expectations
according to: 

0
 if πτ = 0, ∀τ < t
πte =


λθκ otherwise
In other words, as long as the central bank keeps choosing zero inflation, people believe
it will do that in the future. If it chooses some inflation different from zero, people
believe it will choose the inflation consistent with a static equilibrium under discretion,
which is π = π q = λθκ. Assume that at date τ the central has chosen zero inflation for
every t < τ.
1. What is the value of Wτ if the central bank chooses zero inflation forever (that is,
if it chooses πt = 0 for every t ≥ τ)?
2. Suppose the central bank decides to deviate from the strategy assumed in item 1
and chooses an inflation rate different from zero at date τ (but he does the best
deviation possible). In that case, what is the value of Wτ ?
3. Write a condition on the parameters that makes the value of Wτ you found in item
2 smaller than the value of Wτ you found in item 1. Interpret.
Exercise 12.3
Time starts at date 0. The loss function of the central bank at date t is given by
Lt = ut + γπt2

and the Philips curve is as usual: ut = un − η (πt − πte ). At each date τ, the central
bank minimizes the discounted sum of Lt :
∞
∑ βt−τ Lt
t=τ
We know that under discretion in an one period model, the central bank would choose
π = πd ≡
η
2γ , and we also know that the optimal inflation is zero. Now suppose people
forms their expectations according to:


0
 if πτ = 0, ∀τ < t or πτ 6= 0 for τ ∈ {t − k, ..., t − 1}
πte =
 η


2γ otherwise
In other words, as long as the central bank keeps choosing zero inflation, people
believe it will do that in the future. If he chooses some different inflation at some date,
people believe he will choose the inflation consistent with a static equilibrium under
discretion, π e =
η
2γ , for k periods, where k ≥ 1, and then they will believe he will
choose zero again.
Suppose the central bank is at a date τ such that it has chosen zero inflation in all
previous periods. Is it optimal for the central bank to choose zero inflation in all periods
in the future?
Exercise 12.4
Suppose a central banker loss function (L) depends on inflation (π ) and unemployment
(u) and is given by:
L = u + γπ 2 , γ>0

where γ > 0 and π denotes the inflation rate. The Phillips curve in terms of unemploy-
ment is:
u = un − η (π − π e ) , η>0
where u denotes the unemployment rate, un is the natural unemployment and π e is the
expected inflation.
1. Find the equilibrium π and L under discretion.
2. Find the equilibrium π and L under commitment.
3. Suppose the central banker can deviate from the inflation he promised under
commitment. What is its loss L in that case? Which inflation will it choose?
4. Why do we say the central banker is time inconsistent? Explain in words.
5. Suppose that instead of playing the game with discretion, the central bank can
delegate the conduction of monetary policy to a third party who has a loss func-
tion L̃ = u + αγπ 2 , with α > 1 (who will then play a game under discretion).
Would the central banker be willing to do so? Justify your answer. (10%)
In what follows consider a dynamic version of the problem presented. Time is discrete
and indexed by t ∈ {0, 1, 2, ...}. The central banker loss at function at any date τ is:
∞ ∞ h i
V= ∑ β(t−τ ) Lt = ∑ β(t−τ ) ut + γπt2
t=τ t=τ
The Phillips curve is as before but with time subscripts:
ut = un − η (πt − πte )
Denote by Ldisc , Lcom and Ldev the losses you found in item 1, 2 and 3, respectively.
Denote by π disc , π com and π dev the inflation you found in item 1, 2 and 3, respectively.

6. Suppose the inflation setting game under discretion is played at every date. Also,
assume that agents form expectations according to:

π com

 if πt− j , for all j > 0
πte =
π disc

 otherwise
Write a condition on β that guarantees that the central bank will prefer to cooper-
ate (i.e., choose π = π com at every future date). Write the conditions in terms of
β, Ldisc , Lcom and Ldev . Interpret the condition.
7. In light of your answer to item 6, do you think that guaranteeing that a central
banker will have a long term in his position alleviates or exacerbates the time
inconsistency problem? Explain in words.
Exercise 12.5
[Proposed] A central bank has decided to adopt inflation targeting and is now debating
whether to target 5 percent inflation or zero inflation. The economy is described by the
following Phillips curve:
u = 5 − 0.5 (π − π e )
where u and π are the unemployment rate and inflation rate measured in percentage
points. The social cost of unemployment and inflation is described by the following
loss function:
L = u + 0.05π 2
The central bank would like this loss to be as small as possible.
1. If the central bank commits to targeting 5 percent inflation, what is expected infla-
tion? If the central bank follows through, what is the unemployment rate? What

is the loss from inflation and unemployment?
2. If the central bank commits to targeting zero inflation, what is expected inflation?
If the central bank follows through, what is the unemployment rate? What is the
loss from inflation and unemployment?
3. Based on your answers to items 1 and 2, which inflation target would you recom-
mend? Why?
4. Suppose the central bank chooses to target zero inflation, and expected inflation
is zero. Suddenly, however, the central bank surprises people with 5 percent in-
flation. What is unemployment in this period of unexpected inflation? What is
the loss from inflation and unemployment?
5. What problem does your answer to part 4 illustrate?
Exercise 12.6
[Proposed] Suppose the loss function of the central bank is given by
V = π 2 + λ ( y − y − κ )2 .
The Phillips curve is given by y = y + θ (π − π e ). The parameters λ,θ and κ are both
strictly larger than zero.
1. Compute the equilibrium inflation under discretion.
2. Compute the equilibrium inflation under full commitment.
3. Is the central bank loss larger under discretion or under full commitment? Justify
doing the algebra.
4. What happens when κ = 0? Explain with equations and words.

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Workbook - Macroeconomics II

Pontificia Universidad Católica de Chile

Professor: Caio Machado (caio.machado@uc.cl)

Last updated: June 6, 2019

6 Goods and money markets 32

Macroeconomía II, 2019/1 2

(a) A credit card;

(b) A painting by Rembrandt;

(c) A subway token;

1. All money is held as currency.

Macroeconomía II, 2019/1 3

1. Compute the M1 money multiplier (that is M1/H) as a function of θ.

2. Compute the M2 money multiplier (that is M2/H) as a function θ.

3. Find a condition that implies a M1 money multiplier smaller than one.

Macroeconomía II, 2019/1 4

3. Still on the FRED website, find data on:

(a) Excess reserves (e.g., “Excess Reserves of Depository Institutions”);

(b) Reserves (e.g., “Reserve Balances with Federal Reserve Banks”);

(c) Demand deposits (e.g., “Total Checkable Deposits”).

4. Read the article available on https://tinyurl.com/hd2zsxp and explain why US

Macroeconomía II, 2019/1 5

1. What is the money multiplier if we define money as M1?

1. What is the money multiplier if we define money as M1?

Macroeconomía II, 2019/1 6

1. Compute the increase in the money supply in this economy.

Macroeconomía II, 2019/1 7

Macroeconomía II, 2019/1 8

Macroeconomía II, 2019/1 9

1. Show that the household choice satisfies:

Interpret this equation.

Macroeconomía II, 2019/1 10

Macroeconomía II, 2019/1 11

Macroeconomía II, 2019/1 12

2. How do both results relate? Explain each difference you find.

Macroeconomía II, 2019/1 13

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

k −1 = k > 0, B−1 = B > 0, M−1 = M > 0

Macroeconomía II, 2019/1 14

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

where h(it−1 , it , ψ) is a function of it−1 , it and ψ. Derive the functional form of

1. Write down the household’s decision problem.

2. Write down the household’s first-order conditions.

3. Derive the Euler equation.

Macroeconomía II, 2019/1 15

5. Explain what happens to the nominal interest rate in 3 scenarios:

(a) Moneys grows at a constant rate: Mt /Mt−1 = 1 + µ;

(b) Money grows at an increasing rate: Mt /Mt−1 = 1 + µt;

(c) Money grows at a decreasing rate: Mt /Mt−1 = 1 + 1/ (µt).

Macroeconomía II, 2019/1 16

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

B−1 = B > 0, M−1 = M > 0

Macroeconomía II, 2019/1 17

1. Write down the household problem in real units.

2. Derive the first order conditions of the household problem.

3. Write the first order condition of the firm.

4. Show that in equilibrium Rt = f 0 (k t−1 ) and rt = Rt+1 − δ .

[Proposed] Suppose the representative household chooses consumption of cash goods

Macroeconomía II, 2019/1 18

subject to the nominal budget constraint

Pt (ct + dt ) + Mt + Bt = Wt nt + (1 + it−1 ) Bt−1 + Tt + Mt−1

and a cash-in-advance constraint of the form

1. Write the cash-in-advance constraint and budget constraint in real units.

2. Derive the first order conditions with respect to ct , nt , dt and bt .