ECON20532

Macroeconomic Analysis 4

Spring 2019

1 Tutorial 5

1.1 Question 1

Consider an overlapping generations economy in which capital pays a 25 percent net rate of return. The population of a generation grows by 10 percent each period. In the initial period (period 1), there are 100 people and a preexisting fiat money stock of M0 = $1 million. Because of a political impasse, government expenditures exceed (nonseigniorage) tax revenues by 50 goods per young person in every period. Each young person wishes to hold real money balances worth 200 goods regardless of the rate of infiation. a. Use the government budget constraint to find the rate of fiat money creation that is required to finance the excess of government expenditures over taxes. Find also the fiat money stock and the price level in periods 1 and 2.

b. Suppose that in the initial period, the monetary authority hesitates to print new money, forcing the government to issue debt at the market rate of interest. In the second period, the monetary authority relents, printing enough new money to pay off the debt as well as to pay for the second period's excess of government expenditures over taxes. Find the fiat money stock in period 2 and compare it with your answers in part a. Explain the difference.

1.2 Question 2

Suppose the government must borrow 1,000 goods in period 1. Let the gross real marginal product of capital equal 1.07. Assume that people always want to hold fiat money balances worth a total of 100 goods and that the fiat money stock in period 1 is $10,000. Suppose people expect the government to increase the fiat money stock by 100 percent and that the population is constant.

a. What will the nominal net interest rate be?

b. What will the real value of the debt in period 2 be?

c. What will it be if the fiat money stock rises by 10 percent but this rise is unexpected (and people still expect an increase of fiat money by 100%)?