Problem Set - Money and Credit Models

Throughout this problem set, use the standard environment described below except as explicitly stated
otherwise in the problem statements:

The model uses discrete, infinite time, where each period has two subperiods (DM and CM), and with
period discount rate β or 1/(1 + ρ). There are two agent types, Buyers and Sellers, each of measure one.
In the first subperiod a share σ of buyers and sellers are bilaterally matched in a decentralized market.
Sellers are capable of producing a good q in the DM, and Buyers are capable of consuming it. In the
second subperiod, anyone can meet and trade in a centralized market. Both agent types are capable of
producing and/or consuming a good x in the CM, at the cost of labor y. Buyers have utility function
U b = u(q) + x − y and Sellers have utility U s = −c(q) + x − y, where u(q) is an increasing, concave
function and c(q) is an increasing, convex function, and where u(0) = 0 and q(0) = 0. Bargaining in
the DM is described by proportional distribution of the surplus, where the Buyer’s bargaining power is
θ ∈ [0, 1]. Both goods q and x are perishable, and must be consumed in the same subperiod in which
they are produced.

1) Credit with Imperfect Recordkeeping

In addition to the standard environment above, there is a recordkeeping technology that monitors a
share of buyers ω ∈ (0, 1), and defaults by monitored buyers are recorded with probability p ∈ (0, 1].
Records are permanent, and freely accessible by sellers.

a) What is the equilibrium when a seller matches with an unmonitored buyer? Write the DM value
function for a monitored buyer.

b) Write the repayment condition for the buyer, and use that to find the repayment equation in the
(q, y) space.

c) How does p affect efficiency? What about ω? d) Now consider an intervention where buyers are

taxed by an amount τ every CM, and the monitored share of buyers becomes ωτ > ω. Can this
intervention improve efficiency? Write the condition under which this intervention would increase total
welfare.

e) Alternatively, consider an intervention where buyers are taxed by an amount τ every CM, and the
recording probability becomes pτ > p. Can this intervention improve efficiency? Write the condition
under which this intervention would increase total welfare.

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2) Welfare Cost of Inflation:

Assume the money growth model from lecture, where the money supply follows Mt+1 = (1 + γ)Mt ,
√
provided via lump-sum transfers to the buyers. In addition, assume that u(q) = q and c(q) = q 2 , the
discount rate is ρ = 0.03, the buyers and sellers have equal bargaining power (θ = 0.5), and that the
matching rate σ = 0.8.

a) Write the equation describing the welfare cost of inflation, but substitute in the explicit forms for
c′ (q), u′ (q) and ρ. Also calculate an explicit numeric value for the efficient quantity (q ∗ ).

b) Real GDP per period in this model is the total amount of real balances spent on both goods. Use
the explicit forms of u(q) and c(q), and the bargaining condition to write an expression for real GDP
in terms of q.

c) If the rate of inflation is 7%, what is the ratio of real GDP to the efficient level of GDP?

d) Calibration of this model to actual data estimates that θ = 0.5, and a 10% difference between
inflation and the Friedman rule, would reduce GDP by 3.2%. Given your results in part c), what could
account for the difference between your results and the calibrated values in published papers? (In other
words, what parameter values or functional forms used in this problem could be incorrect and it what
direction?)

3) Money with Costly Storage:

Assume money is provided via lump-sum transfers to the buyers, where the money supply follows
Mt+1 = (1 + γ)Mt . In addition, sellers have a technology that allows them to store any amount of
good q at fixed cost s. Quantities of the DM good stored in this manner are available for trade in the
CM, are still only consumable by buyers, and perish after the CM ends. For simplicity, sellers decide
whether to store goods or trade in the DM after they are matched, and can only do one or the other.

a) Write the conditions for matched and unmatched sellers to be willing to use storage. Since the CM
market is perfectly competitive, what is the amount of labor (ys ) spent by buyers to obtain DM goods
from sellers that have used the storage technology?

b) From the buyer’s perspective, write the conditions where a buyer would prefer buying stored goods
to accumulating money, and where they would refuse to buy stored goods.

c) Using the above conditions, characterize the possible stationary equilibria in terms of the values of
s and γ using a diagram (and remember that if γ is too high, money becomes worthless).

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4) Money with Counterfeiting

In addition to the standard environment, assume money is provided via lump-sum transfers to the
buyers, where the money supply follows Mt+1 = (1 + γ)Mt . Also add the ability for the buyer to create
any amount of counterfeit notes at the end of the CM at fixed cost k. Counterfeit notes are discovered
at the beginning of the CM, and destroyed. The seller has no means of determining whether they are
being paid in genuine or fake notes in the DM. There are no records of who has passed fake notes.

a) Given the cost of counterfeiting, and the lack of records, write the buyer’s value when choosing
to gain genuine notes and their value when making fake notes. Use these to determine a condition
under which the buyer accumulates genuine money. (You can write everything in terms of real money
balances z.)

b) Set up the buyer’s maximization problem, subject to the bargaining constraint, and the buyer’s
genuine money constraint. Then solve the maximization problem (note that there will be two cases,
depending on whether the genuine money constraint binds or not).

c) There is some cost of counterfeiting k̄ such that the genuine money constraint just barely binds.
Discuss the efficiency of the equilibrium depending on whether k is above or below k̄.

d) What are the welfare implications of policies that would make notes harder to counterfeit (thus
increasing k)? Is there a clear relationship between monetary policy and whether counterfeiting occurs?