Economics 563 Juha Seppälä

Monetary Theory Spring 2008

Introduction to Monetary Economics

Solution to Mock Midterm 2

1 Allais-Baumol-Tobin Model
(a) Average money holdings are simply the cash in hand during the period divided by the lenght of the
period, or,
T  T
1 1 1 2 
Z
m̄ = c(T − t)dt = cT t − ct 
T 0 T 2 0
1 1 cT 2 cT
= cT 2 − cT 2 = =
T 2T 2T 2

(b) The consumer’s optimization problem is simply

1 1
min R × cT + φ .
T 2 T
The first term is the foregone earnings and the second transactions costs. The first-order condition is
simply r
1 φ ⋆ 2φ
Rc − 2 = 0 =⇒ T =
2 T Rc
(c) r r
1 c2 2φ cφ
m̄ = cT ⋆ = × =
2 4 Rc 2R
(d) 1. c ↑ =⇒ T ⋆ ↓, m ↑
2. φ ↑ =⇒ T ⋆ ↑, m ↑
3. R ↑ =⇒ T ⋆ ↓, m ↓
2 IS/LM and a Decrease in the Taxes

Suppose that τ goes down in the Classical model. What happens?

1. Nothing happens to the equilibrium real wage rate, (W/P )⋆ .

2. Nothing happens the aggregate output y ⋆ .
3. Aggregate demand goes up and hence equilibrium price level P ⋆ goes up.
4. IS-curve shifts right and LM-curve shifts left. Therefore, the equilibrium interest rate r⋆ goes up.
5. Finally, c⋆ goes up and i⋆ goes down.

Suppose that τ goes down in the Keynesian model. What happens?

1. Aggregate demand goes up and hence equilibrium price level P ⋆ and output y ⋆ go up.
2. IS-curve shifts right and LM-curve shifts left. Therefore, the equilibrium interest rate r⋆ goes up.
3. Since y ⋆ and P ⋆ go up, n⋆ goes up.
4. Finally, c⋆ goes up. The effect on i⋆ is ambigious.

Again, the problem is that neither the Classical nor the Keynesian model take into account the effect of
government budget constraint. Namely, if government tax collections are decreased government expenditures
must still be financed somehow—either by increasing the government debt or printing more money. The
first will increase interest rates and the second will increase inflation. Both probably have negative effects
on consumption and private investment.

3 Bond Mathematics
(a) You buy emerging-markets 10-year zero-coupon bonds with $1,000,000 and sell short U.S. 10-year
zero-coupon bonds for $1,000,000. Selling short means that you sell bonds that you don’t own; in
other words, you borrow somebody else’s bonds and you return them later on. Hence, you have to buy
later on the bonds that you sold now.
(b) Nothing. You sell the U.S. bond for $1,000,000 and you buy the emerging-markets bonds with
$1,000,000 you just earned.
(c) Let’s use the approximation formula first:
N N −m N −m
rt,t+m = yt+m + N (ytN − yt+m )

Your rate of return for the U.S. bonds is

10
rt,t+1 = 10 + 10 × (5 − 10) = −40%.

2
 Your rate of return for the emerging-markets bonds is
10
rt,t+1 = 10 + 10 × (10 − 10) = 10%.

Now, with respect to the U.S. bonds your profit will be (1 − 0.40) × (−$1, 000, 000) = −$600, 000 and
with respect to the emerging-markets bonds your profit will be (1 + 0.10) × $1, 000, 000) = $1, 100, 000.
Therefore, your total profit will be $1, 100, 000 − $600, 000 = $500, 000 and you didn’t have to put any
money down.
Let’s use the true formula next:
N (1 + yt )N
rt,t+1 = − 1.
(1 + yt+1 )N −1
Your rate of return for the U.S. bonds is

10 (1 + 0.5)10
rt,t+1 = − 1 = −31%
(1 + 0.1)9

Your rate of return for the emerging-markets bonds is

10 (1 + 0.1)10
rt,t+1 = − 1 = 10%
(1 + 0.1)9

Now, with respect to the U.S. bonds your profit will be (1 − 0.31) × (−$1, 000, 000) = −$690, 000 and
with respect to the emerging-markets bonds your profit will be (1 + 0.10) × $1, 000, 000) = $1, 100, 000.
Therefore, your total profit will be $1, 100, 000 − $690, 000 = $410, 000. Notice the difference caused
by an approximation error.
(d) Let’s use the approximation formula first. Your rate of return for the U.S. bonds is

10 (1 + 0.5)10
rt,t+1 = − 1 = 5%
(1 + 0.05)9

Your rate of return for the emerging-markets bonds is

10
rt,t+1 = 20 + 10 × (10 − 20) = −80%.

Now, with respect to the U.S. bonds your profit will be (1 + 0.05) × (−$1, 000, 000) = −$1, 050, 000
with respect to the emerging-markets bonds your profit will be (1 − 0.80) × $1, 000, 000 = $200, 000.
Therefore, your total profit will be $200, 000 − $1, 050, 000 = −$850, 000. You just lost $850,000!
Let’s use the true formula next. Your rate of return for the U.S. bonds is

10 (1 + 0.5)10
rt,t+1 = − 1 = 5%
(1 + 0.05)9

Your rate of return for the emerging-markets bonds is

10 (1 + 0.1)10
rt,t+1 = − 1 = −50%
(1 + 0.2)9

Now, with respect to the emerging-markets bonds your profit will be (1−0.50)×$1, 000, 000 = $500, 000.
Therefore, your total profit will be $500, 000 − $1, 050, 000 = −$550, 000. Notice the difference caused
by an approximation error.

3
4 Welfare Cost of Inflation

R = 0.03 + 1 = 1.03. This means that y/m will decrease to 12.17.

Next, let us normalize y = 1 which means that we are calculating the costs as a fraction of one year’s GDP.
In this case, m0 = 0.1677 and m1 = 0.0822.

Therefore, we need to calculate the integral

m(r) 0.1677  5
0.08266
Z Z
ψ(m) dm = dm.
m(R) 0.0822 m

The steps are as follows.

0.1677 0.1677
1 −4 
Z
5
0.08266 m −5
dm = 0.0000039 m 
0.0822 −4 0.0822
 
0.1677−4 − 0.0822−4
= 0.0000039
−4
 
1295 − 21932.5
= 0.0000039
−4
= 0.0199.

That is, a 100 percent inflation rate leads to a social cost of 2% of the annual GDP.